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Financial & Management Accounting

Objectives

To acquaint the students with the fundamentals principles of


financial, cost and management accounting
To enable the students to prepare, analyse and interpret financial
statements and
To enable the students to take decisions using management
accounting tools.

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Unit-I
Book-Keeping and Accounting Financial Accounting Concepts
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and Conventions Double Entry System Preparation of Journal, Ledger
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and Trial Balance Preparation of Final Accounts Trading, Profit
and Loss Account and Balance Sheet With Adjustment Entries, Simple
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Problems Only - Capital and Revenue Expenditure and Receipts.


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Unit-II
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Depreciation Causes Methods of Calculating Depreciation


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Straight Line Method, Diminishing Balance Method and Annuity Method


- Ratio Analysis Uses and Limitations Classification of Ratios
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Liquidity, Profitability, Financial and Turnover Ratios Simple Problems


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Only.
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Unit-III
Funds Flow Analysis Funds From Operation, Sources and Uses of
Funds, Preparation of Schedule of Changes In Working Capital and Funds
Flow Statements Uses And Limitations - Cash Flow Analysis Cash From
Operation Preparation of Cash Flow Statement Uses and Limitations
Distinction Between Funds Flow and Cash Flow Only Simple Problems

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Unit-IV
Marginal Costing - Marginal Cost and Marginal Costing -
Importance - Break-Even Analysis - Cost Volume Profit Relationship
Application of Marginal Costing Techniques, Fixing Selling Price, Make
or Buy, Accepting a Foreign Order, Deciding Sales Mix.

Unit-V
Cost Accounting - Elements of Cost - Types of Costs - Preparation
of Cost Sheet Standard Costing Variance Analysis Material Variances
Labour Variances Simple Problems Related to Material And Labour
Variances Only.

[note: distribution of questions between problems and theory of this

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paper must be 60:40 i.e., problem questions: 60 % & theory questions:

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40 %]

REFERENCES s.
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Jelsy Josheph Kuppapally, ACCOUNTING FOR MANAGERS, PHI, delhi,
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2010.
Paresh Shah, BASIC ACCOUNTING FOR MANAGERS, Oxford, Delhi,
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2007.
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Ambrish Gupta, FINANCIAL ACCOUNTING FOR MANAGEMENT,


Pearson, Delhi, 2004.
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Narayanaswamy R, FINANCIAL ACCOUNTING , PHI, Delhi, 2011.


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UNIT I: Basics of Accounting

Lesson 1.1 Accounting An Introduction

1.1.1 Introduction

Accounting is aptly called the language of business. This designation


is applied to accounting because it is the method of communicating
business information. The basic function of any language is to serve as
a means of communication. Accounting duly serves this function. The
task of learning accounting is essentially the same as the task of learning

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a new language. But the acceleration of change in business organization

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has contributed to increase the complexities in this language. Like other
languages, it is undergoing continuous change in an attempt to discover
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better means of communications. To enable the accounting language to
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convey the same meaning to all stakeholders, it should be made standard.
To make it a standard language certain accounting principles, concepts
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and standards have been developed over a period of time. This lesson
dwells upon the different dimensions of accounting, accounting concepts,
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accounting principles and the accounting standards.


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1.1.2 Learning Objectives


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After reading this lesson, the reader should be able to:


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Know the Evolution of Accounting


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Understand the Definition of Accounting


Comprehend the Scope and Function of Accounting
Ascertain the Users of Accounting Information
Know the Specialized Accounting Fields
Understand the Accounting Concepts and Conventions
Realize the Need for Accounting Standards

1.1.3 Contents

1. Evolution of accounting
2. Book keeping and accounting

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3. Definition of accounting
4. Scope and functions of accounting
5. Groups interested in accounting information
6. The profession of accounting
7. Specialized accounting fields
8. Nature and meaning of accounting principles
9. Accounting concepts
10. Accounting conventions
11. Summary
12. Key words
13. Self assessment questions

1.1.3.1 Evolution Of Accounting

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Accounting is as old as money itself. It has evolved, as have medicine,
law and most other fields of human activity in response to the social and
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economic needs of society. People in all civilizations have maintained
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various types of records of business activities. The oldest known are
clay tablet records of the payment of wages in babylonia around 600 b.c.
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accounting was practiced in india twenty-four centuries ago as is clear


from kautilyas book arthshastra which clearly indicates the existence and
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need of proper accounting and audit.


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For the most part, early accounting dealt only with limited aspects
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of the financial operations of private or governmental enterprises.


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Complete accounting system for an enterprise which came to be called


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as double entry system was developed in italy in the 15th century. The
first known description of the system was published there in 1494 by a
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franciscan monk by the name luca pacioli.

The expanded business operations initiated by the industrial


revolution required increasingly large amounts of money which in turn
resulted in the development of the corporation form of organizations.
As corporations became larger, an increasing number of individuals and
institutions looked to accountants to provide economic information about
these enterprises. For e.g. Prospective investors and creditors sought
information about a corporations financial status. Government agencies
required financial information for purposes of taxation and regulation.
Thus accounting began to expand its function of meeting the needs of

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relatively few owners to a public role of meeting the needs of a variety of


interested parties.

1.1.3.2 Book Keeping And Accounting

Book-keeping is that branch of knowledge which tells us how


to keep a record of business transactions. It is considered as an art of
recording systematically the various types of transactions that occur in a
business concern in the books of accounts. According to spicer and pegler,
book-keeping is the art of recording all money transactions, so that
the financial position of an undertaking and its relationship to both its
proprietors and to outside persons can be readily ascertained. Accounting
is a term which refers to a systematic study of the principles and methods

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of keeping accounts. Accountancy and book-keeping are related terms; the

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former relates to the theoretical study and the latter refers to the practical
work.
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1.1.3.3 Definition Of Accounting
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Before attempting to define accounting, it may be made clear that


there is no unanimity among accountants as to its precise definition.
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Anyhow let us examine three popular definitions on the subject:


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Accounting has been defined by the american accounting association


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committee as:
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the process of identifying, measuring and communicating economic


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information to permit informed judgments and decisions by users of the


information. This may be considered as a good definition because of its
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focus on accounting as an aid to decision making.

The american institute of certified and public accountants committee on


terminology defined accounting as:

accounting is the art of recording, classifying and summarizing, in a


significant manner and in terms of money, transactions and events
which are, in part at least, of a financial character and interpreting the
results thereof . of all definitions available, this is the most acceptable one
because it encompasses all the functions which the modern accounting
system performs.

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Another popular definition on accounting was given by american


accounting principles board in 1970, which defined it as:

accounting is a service society. Its function is to provide quantitative


information, primarily financial in nature, about economic entities that
is useful in making economic decision, in making reasoned choices among
alternative courses of action.

This is a very relevant definition in a present context of business


units facing the situation of selecting the best among the various alternatives
available. The special feature of this definition is that it has designated
accounting as a service activity.

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1.1.3.4 Scope And Functions Of Accounting

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Individuals engaged in such areas of business as finance,
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production, marketing, personnel and general management need not be
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expert accountants but their effectiveness is no doubt increased if they
have a good understanding of accounting principles. Everyone engaged
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in business activity, from the bottom level employee to the chief executive
and owner, comes into contact withaccounting. The higher the level of
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authority and responsibility, the greater is the need for an understanding


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of accounting concepts and terminology.


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A study conducted in united states revealed that the most common


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background of chief executive officers in united states corporations was


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finance and accounting. Interviews with several corporate executives drew


the following comments:
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my training in accounting and auditing practice has been extremely


valuable to me throughout. a knowledge of accounting carried with it
understanding of the establishment and maintenance of sound financial
controls- is an area which is absolutely essential to a chief executive
officer.

Though accounting is generally associated with business, it is


not only business people who make use of accounting but also many
individuals in non-business areas that make use of accounting data and
need to understand accounting principles and terminology. For e.g. An
engineer responsible for selecting the most desirable solution to a technical

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manufacturing problem may consider cost accounting data to be the


decisive factor. Lawyers want accounting data in tax cases and damages
from breach of contract. Governmental agencies rely on an accounting data
in evaluating the efficiency of government operations and for approving
the feasibility of proposed taxation and spending programs. Accounting
thus plays an important role in modern society and broadly speaking all
citizens are affected by accounting in some way or the other.

Accounting which is so important to all, discharges the following vital


functions:

Keeping Systematic Records:

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This is the fundamental function of accounting. The transactions

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of the business are properly recorded, classified and summarized into final
financial statements income statement and the balance sheet.
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Protecting The Business Properties:
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The second function of accounting is to protect the properties


of the business by maintaining proper record of various assets and thus
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enabling the management to exercise proper control over them.


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Communicating The Results:


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As accounting has been designated as the language of business, its


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third function is to communicate financial information in respect of net


profits, assets, liabilities, etc., to the interested parties.
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Meeting Legal Requirements:

The fourth and last function of accounting is to devise such a


system as will meet the legal requirements. The provisions of various laws
such as the companies act, income tax act, etc., require the submission of
various statements like income tax returns, annual accounts and so on.
Accounting system aims at fulfilling this requirement of law.

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It may be noted that the functions stated above are those of financial
accounting alone. The other branches of accounting, about which we
are going to see later in this lesson, have their special functions with the
common objective of assisting the management in its task of planning,
control and coordination of business activities. Of all the branches of
accounting, management accounting is the most important from the
management point of view.

As accounting is the language of business, the primary aim of


accounting, like any other language, is to serve as a means of communication.
Most of the worlds work is done through organizations groups of people
who work together to accomplish one or more objectives. In doing its work,
an organization uses resources men, material, money and machine and

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various services. To work effectively, the people in an organization need

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information about these sources and the results achieved through using
them. People outside the organization need similar information to make
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judgments about the organization. Accounting is the system that provides
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such information.
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Any system has three features, viz., input, processes and output.
Accounting as a social science can be viewed as an information system,
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since it has all the three features i.e., inputs (raw data), processes (men
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and equipment) and outputs (reports and information). Accounting


information is composed principally of financial data about business
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transactions. The mere records of transactions are of little use in making


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informed judgments and decisions. The recorded data must be sorted


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and summarized before significant analysis can be prepared. Some of


the reports to the enterprise manager and to others who need economic
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information may be made frequently; other reports are issued only at


longer intervals. The usefulness of reports is often enhanced by various
types of percentage and trend analyses. The basic raw materials of
accounting are composed of business transactions data. Its primary end
products are composed of various summaries, analyses and reports.
The information needs of a business enterprise can be outlined and
illustrated with the help of the following chart:

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Chart Showing Types Of Information

Information

Non-quantitative Quantitative
Information Information

Accounting Non- accounting


Information Information

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Operating Financial Management Cost
Information Information s.
Information Information
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The chart clearly presents the different types of information


that might be useful to all sorts of individuals interested in the business
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enterprise. As seen from the chart, accounting supplies the quantitative


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information. The special feature of accounting as a kind of a quantitative


information and as distinguished from other types of quantitative
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information is that it usually is expressed in monetary terms.


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In this connection it is worthwhile to recall the definitions of


accounting as given by the american institute of certified and public
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accountants and by the american accounting principles board.

The types of accounting information may be classified into four


categories: (1) operating information, (2) financial accounting information
(3) management accounting information and (4) cost accounting
information.

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Operating Information:

By operating information, we mean the information which is


required to conduct the day-to-day activities. Examples of operating
information are: amount of wages paid and payable to employees,
information about the stock of finished goods available for sale and each
ones cost and selling price, information about amounts owed to and owing
by the business enterprise, information about stock of raw materials, spare
parts and accessories and so on. By far, the largest quantity of accounting
information provides the raw data (input) for financial accounting,
management accounting and cost accounting.

Financial Accounting:

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Financial accounting information is intended both for owners and
managers and also for the use of individuals and agencies external to the
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business. This accounting is concerned with the recording of transactions
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for a business enterprise and the periodic preparation of various reports
from such records. The records may be for general purpose or for a special
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purpose. A detailed account of the function of financial accounting has


been given earlier in this lesson.
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Management Accounting:
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Management accounting employs both historical and estimated


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data in assisting management in daily operations and in planning for


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future operations. It deals with specific problems that confront enterprise


managers at various organizational levels. The management accountant
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is frequently concerned with identifying alternative courses of action


and then helping to select the best one. For e.g. The accountant may help
the finance manager in preparing plans for future financing or may help
the sales manager in determining the selling price to be fixed on a new
product by providing suitable data. Generally management accounting
information is used in three important management functions: (1) control
(2) co-ordination and (3) planning. Marginal costing is an important
technique of management accounting which provides multi dimensional
information that facilitates decision making.

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Cost Accounting:

The industrial revolution in england posed a challenge to


the development of accounting as a tool of industrial management.
This necessitated the development of costing techniques as guides to
management action. Cost accounting emphasizes the determination and
the control of costs. It is concerned primarily with the cost of manufacturing
processes. In addition, one of the principal functions of cost accounting
is to assemble and interpret cost data, both actual and prospective, for the
use of management in controlling current operations and in planning for
the future.

All of the activities described above are related to accounting and

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in all of them the focus is on providing accounting information to enable

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decisions to be made. More about cost accounting can be gained in unit v.

1.1.3.5 Groups Interested In Accounting Information s.


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There are several groups of people who are interested in the
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accounting information relating to the business enterprise. Following are


some of them:
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Shareholders:
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Shareholders as owners are interested in knowing the profitability


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of the business transactions and the distribution of capital in the form of


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assets and liabilities. In fact, accounting developed several centuries ago


to supply information to those who had invested their funds in business
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enterprise.

Management:

With the advent of joint stock company form of organization the


gap between ownership and management widened. In most cases the
shareholders act merely as renders of capital and the management of the
company passes into the hands of professional managers. The accounting
disclosures greatly help them in knowing about what has happened and
what should be done to improve the profitability and financial position of
the enterprise.

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Potential Investors:

An individual who is planning to make an investment in a business


would like to know about its profitability and financial position. An
analysis of the financial statements would help him in this respect.

Creditors:

As creditors have extended credit to the company, they are much


worried about the repaying capacity of the company. For this purpose they
require its financial statements, an analysis of which will tell about the
solvency position of the company.

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Government:

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Any popular government has to keep a watch on big businesses
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regarding the manner in which they build business empires without regard
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to the interests of the community. Restricting monopolies is something
that is common even in capitalist countries. For this, it is necessary that
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proper accounts are made available to the government. Also, accounting


data are required for collection of sale-tax, income-tax, excise duty etc.
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Employees:
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Like creditors, employees are interested in the financial statements


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in view of various profit sharing and bonus schemes. Their interest may
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further increase when they hold shares of the companies in which they are
employed.
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Researchers:

Researchers are interested in interpreting the financial statements


of the concern for a given objective.

Citizens:

Any citizen may be interested in the accounting records of business


enterprises including public utilities and government companies as a voter
and tax payer.

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1.1.3.6 The Profession Of Accounting

Accountancy can very well be viewed as a profession with


stature comparable to that of law or medicine or engineering. The rapid
development of accounting theory and techniques especially after the
late thirties of 20th century has been accompanied by an expansion of
the career opportunities in accounting and an increasing number of
professionally trained accountants. Among the factors contributing to this
growth has been the increase in number, size and complexity of business
enterprises, the imposition of new and increasingly complex taxes and
other governmental restrictions on business operations.

Coming to the nature of accounting function, it is no doubt a

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service function. The chief of accounting department holds a staff position

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which is quite in contra - distinction to the roles played by production or
marketing executives who hold line authority. The role of the accountant
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is advisory in character. Although accounting is a staff function performed
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by professionals within an organization, the ultimate responsibility
for the generation of accounting information, whether financial or
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managerial, rests with management. That is why one of the top officers of
many businesses is the financial controller. The controller is the person
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responsible for satisfying other managers demands for management


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accounting information and for complying with the regulatory demands


of financial reporting. With these ends in view, the controller employs
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accounting professionals in both management and financial accounting.


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These accounting professionals employed in a particular business firm


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are said to be engaged in private accounting. Besides these, there are also
accountants who render accounting services on a fee basis through staff
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accountants employed by them. These accountants are said to be engaged


in public accounting.

1.1.3.7 Specialised Accounting Fields

As in many other areas of human activity, a number of specialized


fields in accounting also have evolved besides financial accounting.
Management accounting and cost accounting are the result of rapid
technological advances and accelerated economic growth. The most
important among them are explained below:

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Tax Accounting:

Tax accounting covers the preparation of tax returns and the


consideration of the tax implications of proposed business transactions
or alternative courses of action. Accountants specializing in this branch of
accounting are familiar with the tax laws affecting their employer or clients
and are up to date on administrative regulations and court decisions on
tax cases.

International Accounting:

This accounting is concerned with the special problems associated


with the international trade of multinational business organizations.

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Accountants specializing in this area must be familiar with the influences

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that custom, law and taxation of various countries bring to bear on
international operations and accounting principles.
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Social Responsibility Accounting:
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This branch is the newest field of accounting and is the most


difficult to describe concisely. It owes its birth to increasing social
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awareness which has been particularly noticeable over the last three
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decades or so. Social responsibility accounting is so called because it not


only measures the economic effects of business decisions but also their
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social effects, which have previously been considered to be immeasurable.


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Social responsibilities of business can no longer remain as a passive chapter


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in the text books of commerce but are increasingly coming under greater
scrutiny. Social workers and peoples welfare organizations are drawing the
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attention of all concerned towards the social effects of business decisions.


The management is being held responsible not only for the efficient
conduct of business as reflected by increased profitability but also for what
it contributes to social well-being and progress.

Inflation Accounting:

Inflation has now become a world-wide phenomenon. The


consequences of inflation are dire in case of developing and underdeveloped
countries. At this juncture when financial statements or reports are based
on historical costs, they would fail to reflect the effect of changes in

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purchasing power or the financial position and profitability of the firm.


Thus, the utility of the accounting records, not taking care of price level
changes is seriously lost. This imposes a demand on the accountants for
adjusting financial accounting for inflation to know the real financial
position and profitability of a concern. Thus emerged a future branch
of accounting called inflation accounting or accounting for price level
changes. It is a system of accounting which regularly records all items in
financial statements at their current values.

Human Resources Accounting:

Human resources accounting is yet another new field of accounting


which seeks to report and emphasize the importance of human resources

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in a companys earning process and total assets. It is based on the general

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agreement that the only real long lasting asset which an organization
possesses is the quality and caliber of the people working in it. This system
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of accounting is concerned with, the process of identifying and measuring
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data about human resources and communicating this information to
interested parties.
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1.1.3.8 Nature And Meaning Of Accounting Principles


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What is an accounting principle or concept or convention or


standard? Do they mean the same thing? Or does each one has its own
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meaning? These are all questions for which there is no definite answer
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because there is ample confusion and controversy as to the meaning


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and nature of accounting principles. We do not want to enter into this


controversial discussion because the reader may fall a prey to the
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controversies and confusions and lose the spirit of the subject.

The rules and conventions of accounting are commonly referred


to as principles. The american institute of certified public accountants has
defined the accounting principle as, a general law or rule adopted or
professed as a guide to action; a settled ground or basis of conduct or
practice. It may be noted that the definition describes the accounting
principle as a general law or rule that is to be used as a guide to action.
The canadian institute of chartered accountants has defined accounting
principles as, the body of doctrines commonly associated with the theory
and procedure of accounting, serving as explanation of current practices

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and as a guide for the selection of conventions or procedures where


alternatives exist. This definition also makes it clear that accounting
principles serve as a guide to action.

The peculiar nature of accounting principles is that they are


manmade. Unlike the principles of physics, chemistry etc. They were not
deducted from basic axiom. Instead they have evolved. This has been
clearly brought out by the canadian institute of chartered accountants in the
second part of their definition on accounting principles: rules governing
the foundation of accounting actions and the principles derived from them
have arisen from common experiences, historical precedent, statements
by individuals and professional bodies and regulation of governmental
agencies. Since the accounting principles are man made they cannot be

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static and are bound to change in response to the changing needs of the

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society. It may be stated that accounting principles are changing but the
change in them is permanent.
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Accounting principles are judged on their general acceptability to
the makers and users of financial statements and reports. They present
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a generally accepted and uniform view of the accounting profession in


relation to good accounting practice and procedures. Hence the name
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generally accepted accounting principles.


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Accounting principles, rules of conduct and action are described


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by various terms such as concepts, conventions, doctrines, tenets,


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assumptions, axioms, postulates, etc. But for our purpose we shall use all
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these terms synonymously except for a little difference between the two
terms concepts and conventions. The term concept is used to connote
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accounting postulates i.e. Necessary assumptions or conditions upon


which accounting is based. The term convention is used to signify customs
or traditions as a guide to the preparation of accounting statements.

1.1.3.9 Accounting Concepts



The important accounting concepts are discussed hereunder:

Business Entity Concept:

It is generally accepted that the moment a business enterprise is

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started it attains a separate entity as distinct from the persons who own it.
In recording the transactions of a business, the important question is:

How do these transactions affect the business enterprise? The


question as to how these transactions affect the proprietors is quite
irrelevant. This concept is extremely useful in keeping business affairs
strictly free from the effect of private affairs of the proprietors. In the
absence of this concept the private affairs and business affairs are mingled
together in such a way that the true profit or loss of the business enterprise
cannot be ascertained nor its financial position. To quote an example, if a
proprietor has taken rs.5000/- from the business for paying house tax for
his residence, the amount should be deducted from the capital contributed
by him. Instead if it is added to the other business expenses then the profit

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will be reduced by rs.5000/- and also his capital more by the same amount.

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This affects the results of the business and also its financial position. Not
only this, since the profit is lowered, the consequential tax payment also
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will be less which is against the provisions of the income-tax act.
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Going Concern Concept:
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This concept assumes that the business enterprise will continue


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to operate for a fairly long period in the future. The significance of this
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concept is that the accountant while valuing the assets of the enterprise does
not take into account their current resale values as there is no immediate
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expectation of selling it. Moreover, depreciation on fixed assets is charged


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on the basis of their expected life rather than on their market values. When
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there is conclusive evidence that the business enterprise has a limited life,
the accounting procedures should be appropriate to the expected terminal
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date of the enterprise. In such cases, the financial statements could clearly
disclose the limited life of the enterprise and should be prepared from the
quitting concern point of view rather than from a going concern point of
view.

Money Measurement Concept:

Accounting records only those transactions which can be


expressed in monetary terms. This feature is well emphasized in the two
definitions on accounting as given by the american institute of certified
public accountants and the american accounting principles board. The

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importance of this concept is that money provides a common denomination


by means of which heterogeneous facts about a business enterprise can be
expressed and measured in a much better way. For e.g. When it is stated that
a business owns rs.1,00,000 cash, 500 tons of raw material, 10 machinery
items, 3000 square meters of land and building etc., these amounts cannot
be added together to produce a meaningful total of what the business owns.
However, by expressing these items in monetary terms such as rs.1,00,000
cash, rs.5,00,000 worth raw materials, rs,10,00,000 worth machinery items
and rs.30,00,000 worth land and building such an addition is possible.

A serious limitation of this concept is that accounting does not


take into account pertinent non-monetary items which may significantly
affect the enterprise. For instance, accounting does not give information

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about the poor health of the chairman, serious misunderstanding between

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the production and sales manager etc., which have serious bearing on
the prospects of the enterprise. Another limitation of this concept is
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that money is expressed in terms of its value at the time a transaction is
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recorded in the accounts. Subsequent changes in the purchasing power of
money are not taken into account.
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Cost Concept:
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This concept is yet another fundamental concept of accounting


which is closely related to the going-concern concept. As per this concept:
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(i) an asset is ordinarily entered in the accounting records at the price paid
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to acquire it i.e., at its cost and (ii) this cost is the basis for all subsequent
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accounting for the asset.


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The implication of this concept is that the purchase of an asset is


recorded in the books at the price actually paid for it irrespective of its
market value. For e.g. If a business buys a building for rs.3,00,000, the asset
would be recorded in the books as rs.3,00,000 even if its market value at
that time happens to be rs.4,00,000. However, this concept does not mean
that the asset will always be shown at cost. This cost becomes the basis for
all future accounting of the asset. It means that the asset may systematically
be reduced in its value by changing depreciation. The significant advantage
of this concept is that it brings in objectivity in the preparations and
presentation of financial statements. But like the money measurement
concept, this concept also does not take into account subsequent changes

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in the purchasing power of money due to inflationary pressures. This is


the reason for the growing importance of inflation accounting.

Dual Aspect Concept (Double Entry System):

This concept is the core of accounting. According to this concept


every business transaction has a dual aspect. This concept is explained in
detail below:

The properties owned by a business enterprise are referred to as


assets and the rights or claims to the various parties against the assets are
referred to as equities. The relationship between the two may be expressed
in the form of an equation as follows:

m
co
Equities = Assets

s.
Equities may be subdivided into two principal types: the rights of
bu
creditors and the rights of owners. The rights of creditors represent debts
of the business and are called liabilities. The rights of the owners are called
la

capital.
yl

Expansion of the equation to give recognition to the two types of


lls

equities results in the following which is known as the accounting equation:


.a

Liabilities + Capital = Assets


w
w

It is customary to place liabilities before capital because creditors


have priority in the repayment of their claims as compared to that of
w

owners. Sometimes greater emphasis is given to the residual claim of the


owners by transferring liabilities to the other side of the equation as:

Capital = Assets Liabilities

All business transactions, however simple or complex they are,


result in a change in the three basic elements of the equation. This is well
explained with the help of the following series of examples:

(i) Mr. Prasad commenced business with a capital of rs.3,000: the


result of this transaction is that the business, being a separate entity, gets

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cash-asset of rs.30,000 and has to pay to mr. Prasad rs.30,000, his capital.
This transaction can be expressed in the form of the equation as follows:
Capital = Assets
Prasad Cash
30,000 30,000
(ii) purchased furniture for rs.5,000: the effect of this transaction
is that cash is reduced by rs.5,000 and a new asset viz. Furniture worth
rs.5,000 comes in, thereby, rendering no change in the total assets of the
business. The equation after this transaction will be:
Capital = Assets
Prasad Cash + Furniture
30,000 25,000 + 5,000
(iii) borrowed rs.20,000 from mr. Gopal: as a result of this

m
transaction both the sides of the equation increase by rs.20,000; cash

co
balance is increased and a liability to mr. Gopal is created. The equation
will appear as follows:
s.
Liabilities + Capital = Assets
bu
Creditors + Prasad Cash + Furniture
20,000 30,000 45,000 5,000
la

(iv) purchased goods for cash rs.30,000: this transaction does not
affect the liabilities side total nor the asset side total. Only the composition
yl

of the total assets changes i.e. Cash is reduced by rs.30,000 and a new asset
lls

viz. Stock worth rs.30,000 comes in. The equation after this transaction
will be as follows:
.a

Liabilities + Capital =Asset


w

Creditors Prasad Cash + Stock + Furniture


w

20,000 30,000 15,000 30,000 5,000


(v) goods worth rs.10,000 are sold on credit to ganesh for rs.12,000. The
w

result is that stock is reduced by rs.10,000 a new asset namely debtor (mr.
ganesh) for rs.12,000 comes into picture and the capital of mr. Prasad
increases by rs.2,000 as the profit on the sale of goods belongs to the owner.
Now the accounting equation will look as under:

Liabilities + Capital = Asset


Creditors Prasad Cash + Debtors + Stock + Furniture
20,000 32,000 15,000 12,000 20,000 5,000
(vi) paid electricity charges rs.300: this transaction reduces both the
cash balance and mr. Prasads capital by rs.300. This is so because the
expenditure reduces the business profit which in turn reduces the equity.

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The equation after this will be:


Liabilities + Capital =Assets
Creditors + Prasad Cash + Debtors + Stock + Furniture
20,000 31,700 14,700 12,000 20,000 5,000
Thus it may be seen that whatever is the nature of transaction, the
accounting equation always tallies and should tally. The system of recording
transactions based on this concept is called double entry system.

Accounting Period Concept:

In accordance with the going concern concept it is usually assumed


that the life of a business is indefinitely long. But owners and other

m
interested parties cannot wait until the business has been wound up for

co
obtaining information about its results and financial position. For e.g. If
for ten years no accounts have been prepared and if the business has been
s.
consistently incurring losses, there may not be any capital at all at the end
bu
of the tenth year which will be known only at that time. This would result
in the compulsory winding up of the business. But, if at frequent intervals
la

information are made available as to how things are going, then corrective
measures may be suggested and remedial action may be taken. That is
yl

why, pacioli wrote as early as in 1494: frequent accounting makes for only
lls

friendship. This need leads to the accounting period concept.


.a

According to this concept accounting measures activities for a


w

specified interval of time called the accounting period. For the purpose
w

of reporting to various interested parties one year is the usual accounting


period. Though pacioli wrote that books should be closed each year
w

especially in a partnership, it applies to all types of business organizations.

Periodic Matching Of Costs And Revenues:

This concept is based on the accounting period concept. It is widely


accepted that desire of making profit is the most important motivation to
keep the proprietors engaged in business activities. Hence a major share of
attention of the accountant is being devoted towards evolving appropriate
techniques of measuring profits. One such technique is periodic matching
of costs and revenues.

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In order to ascertain the profits made by the business during


a period, the accountant should match the revenues of the period with
the costs of that period. By matching we mean appropriate association
of related revenues and expenses pertaining to a particular accounting
period. To put it in other words, profits made by a business in a particular
accounting period can be ascertained only when the revenues earned
during that period are compared with the expenses incurred for earning
that revenue. The question as to when the payment was actually received
or made is irrelevant. For e.g. In a business enterprise which adopts
calendar year as accounting year, if rent for december 1989 was paid in
january 1990, the rent so paid should be taken as the expenditure of the
year 1989, revenues of that year should be matched with the costs incurred
for earning that revenue including the rent for december 1989, though

m
paid in january 1990. It is on account of this concept that adjustments are

co
made for outstanding expenses, accrued incomes, prepaid expenses etc.
While preparing financial statements at the end of the accounting period.
s.
bu
The system of accounting which follows this concept is called as
mercantile system. In contrast to this there is another system of accounting
la

called as cash system of accounting where entries are made only when cash
is received or paid, no entry being made when a payment or receipt is
yl

merely due.
lls

Realization Concept:
.a
w

Realization refers to inflows of cash or claims to cash like bills


w

receivables, debtors etc. Arising from the sale of assets or rendering of


services. According to realization concept, revenues are usually recognized
w

in the period in which goods were sold to customers or in which services


were rendered. Sale is considered to be made at the point when the
property in goods passes to the buyer and he becomes legally liable to
pay. To illustrate this point, let us consider the case of a, a manufacturer
who produces goods on receipt of orders. When an order is received from
b, a starts the process of production and delivers the goods to b when
the production is complete. B makes payment on receipt of goods. In this
example, the sale will be presumed to have been made not at the time when
goods are delivered to b. A second aspect of the realization concept is that
the amount recognized as revenue is the amount that is reasonably certain
to be realized. However, lot of reasoning has to be applied to ascertain

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as to how certain reasonably certain is yet, one thing is clear, that is,
the amount of revenue to be recorded may be less than the sales value of
the goods sold and services rendered. For e.g. When goods are sold at a
discount, revenue is recorded not at the list price but at the amount at which
sale is made. Similarly, it is on account of this aspect of the concept that
when sales are made on credit, though entry is made for the full amount
of sales, the estimated amount of bad debts is treated as an expense and
the effect on net income is the same as if the revenue were reported as the
amount of sales minus the estimated amount of bad debts.

1.1.3.10 Accounting Conventions

Convention Of Conservatism:

m
co
It is a world of uncertainty. So it is always better to pursue the
policy of playing safe. This is the principle behind the convention of
s.
conservatism. According to this convention the accountant must be very
bu
careful while recognizing increases in an enterprises profits rather than
recognizing decreases in profits. For this the accountants have to follow the
la

rule, anticipate no profit, provide for all possible losses, while recording
business transactions. It is on account of this convention that the inventory
yl

is valued at cost or market price whichever is less, i.e. When the market
lls

price of the inventories has fallen below its cost price it is shown at market
price i.e. The possible loss is provided and when it is above the cost price
.a

it is shown at cost price i.e. The anticipated profit is not recorded. It is


w

for the same reason that provision for bad and doubtful debts, provision
w

for fluctuation in investments, etc., are created. This concept affects


principally the current assets.
w

Convention Of Full Disclosure:

the emergence of joint stock company form of business


organization resulted in the divorce between ownership and management.
This necessitated the full disclosure of accounting information about
the enterprise to the owners and various other interested parties. Thus
the convention of full disclosure became important. By this convention
it is implied that accounts must be honestly prepared and all material
information must be adequately disclosed therein. But it does not
mean that all information that someone desires are to be disclosed in

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the financial statements. It only implies that there should be adequate


disclosure of information which is of considerable value to owners,
investors, creditors, government, etc. In sachar committee report (1978),
it has been emphasized that openness in company affairs is the best way
to secure responsible behaviour. It is in accordance with this convention
that companies act, banking companies regulation act, insurance act etc.,
have prescribed proforma of financial statements to enable the concerned
companies to disclose sufficient information. The practice of appending
notes relating to various facts on items which do not find place in financial
statements is also in pursuance to this convention. The following are some
examples:

(a) contingent liabilities appearing as a note

m
(b) market value of investments appearing as a note

co
(c) schedule of advances in case of banking companies

Convention Of Consistency: s.
bu
According to this concept it is essential that accounting procedures,
la

practices and method should remain unchanged from one accounting


period to another. This enables comparison of performance in one
yl

accounting period with that in the past. For e.g. If material issues are
lls

priced on the basis of fifo method the same basis should be followed year
after year. Similarly, if depreciation is charged on fixed assets according to
.a

diminishing balance method it should be done in subsequent year also. But


w

consistency never implies inflexibility as not to permit the introduction


w

of improved techniques of accounting. However if introduction of a new


technique results in inflating or deflating the figures of profit as compared
w

to the previous methods, the fact should be well disclosed in the financial
statement.

Convention Of Materiality:

The implication of this convention is that accountant should


attach importance to material details and ignore insignificant ones. In the
absence of this distinction, accounting will unnecessarily be overburdened
with minute details. The question as to what is a material detail and what
is not is left to the discretion of the individual accountant. Further, an
item should be regarded as material if there is reason to believe that

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knowledge of it would influence the decision of informed investor. Some


examples of material financial information are: fall in the value of stock,
loss of markets due to competition, change in the demand pattern due to
change in government regulations, etc. Examples of insignificant financial
information are: rounding of income to nearest ten for tax purposes etc.
Sometimes if it is felt that an immaterial item must be disclosed, the
same may be shown as footnote or in parenthesis according to its relative
importance.

1.1.3.11 Summary

Accounting is rightly called the language of business. It is as old as


money itself. It is concerned with the collecting, recording, evaluating and

m
communicating the results of business transactions. Initially meant to meet

co
the needs of a relatively few owners, it gradually expanded its functions to
a public role of meeting the needs of a variety of interested parties. Broadly
s.
speaking all citizens are affected by accounting in some way. Accounting
bu
as an information system possesses with accountants engaged in private
and public accounting. As in many other areas of human activity a number
la

of specialized fields in accounting also have evolved as a result of rapid


changes in business and social needs.
yl
lls

Accounting information should be made standard to convey


the same meaning to all interested parties. To make it standard, certain
.a

accounting principles, concepts, conventions and standards have been


w

developed over a period of time. These accounting principles, by whatever


w

name they are called, serve as a general law or rule that is to be used as a
guide to action. Without accounting principles, accounting information
w

becomes incomparable, inconsistent and unreliable. An accounting


principle to become generally accepted should satisfy the criteria of
relevance, objectivity and feasibility. The fasb (financial accounting
standards board) is currently the dominant body in the development of
accounting principles. The iasc is another professional body which is
engaged in the development of the accounting standards. The icai is an
associate member of the iasc and the asb started by the icai is formulating
accounting standards in our country. Both the iasc and icai consider going
concern, accrual and consistency as fundamental accounting assumptions.

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1.1.3.12 Key Words

Accounting: language of business.


Financial Accounting: concerned with the recording of
transactions for a business enterprise and the periodic preparation
of various reports from such records
Management Accounting: accounting for internal management
needs.
Cost Accounting: accounting for determination and control of
costs.
Accounting Principle: the body of doctrines commonly associated
with the theory and procedure of accounting.
Accounting Concept: accounting postulates i.e. Necessary

m
assumptions or conditions upon which accounting is based.

co
Accounting Conventions: convention signifies the customs or
traditions which serve as a guide to the preparation of accounting
statements. s.
bu
Accounting Standard: standards to be observed in the presentation
of financial statements.
la


1.1.3.13 Self Assessment Questions
yl

1. Why is accounting called the language of business?


lls

2. What are the functions of accounting?


3. Accounting as a social science can be viewed as an information
.a

system. examine.
w

4. Is accounting a staff function or line function? Explain the reasons.


w

5. Give an account of the various branches of accounting.


6. accounting is a service function. Discuss the statement in the
w

context of a modern manufacturing business.


7. Distinguish between financial accounting and management
accounting.
8. What are accounting concepts and conventions? Is there any
difference between them?
9. What is the significance of dual aspect concept?
10. Write a short note on accounting standards.
11. What is the position in india regarding the formulation and
enforcement of accounting standards?

*****

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Lesson 1.2 The Accounting Process

1.2.1 Introduction

During the accounting period the accountant records transactions


as and when they occur. At the end of each accounting period the accountant
summarizes the information recorded and prepares the trial balance to
ensure that the double entry system has been maintained. This is often
followed by certain adjusting entries which are to be made to account the
changes that have taken place since the transactions were recorded. When

m
the recording aspect has been made as complete and upto-date as possible

co
the accountant prepares financial statements reflecting the financial
position and the results of business operations. Thus the accounting
process consists of three major parts: s.
bu
i.The recording of business transactions during that period;
la

ii.The summarizing of information at the end of the period and


iii.The reporting and interpreting of the summary information.
yl
lls

The success of the accounting process can be judged from the


responsiveness of financial reports to the needs of the users of accounting
.a

information. This lesson takes the readers into the accounting process.
w
w

1.2.2 Learning Objectives


w

After reading this lesson the reader should be able to:

nderstand the Rules of Debit and Credit


U
Pass Journal Entries
Prepare Ledger Accounts
Prepare a Trial Balance
Make Adjustment and Closing Entries
Get Introduced to Tally Package

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1.2.3 Contents

1.2.3.1 the account


1.2.3.2 debit and credit
1.2.3.3 the ledger
1.2.3.4 journal
1.2.3.5 the trial balance
1.2.3.6 closing entries
1.2.3.7 adjustment entries
1.2.3.8 preparation of financial statements
1.2.3.9 introduction to tally package
1.2.3.10 summary

m
1.2.3.11 key words

co
1.2.3.12 self assessment questions

1.2.3.1 The Account s.


bu
The transactions that take place in a business enterprise during
la

a specific period may effect increases and decreases in assets, liabilities,


capital, revenue and expense items. To make up to-date information
yl

available when needed and to be able to prepare timely periodic financial


lls

statements, it is necessary to maintain a separate record for each item. For


e.g. It is necessary to have a separate record devoted exclusively to record
.a

increases and decreases in cash, another one to record increases and


w

decreases in supplies, a third one on machinery, etc. The type of record


w

that is traditionally used for this purpose is called an account. Thus an


account is a statement wherein information relating to an item or a group
w

of similar items are accumulated. The simplest form of an account has


three parts:
i. A title which gives the name of the item recorded in the account
ii. A space for recording increases in the amount of the item, and
iii. A space for recording decreases in the amount of the item. This
form of an account is known as a t account because of its similarity
to the letter t as illustrated below:
Title
Left side Right side
(debit side) (credit side)

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1.2.3.2 Debit And Credit

The left-hand side of any account is called the debit side and the
right-hand side is called the credit side. Amounts entered on the left hand
side of an account, regardless of the tile of the account are called debits
and the amounts entered on the right hand side of an account are called
credits. To debit (dr) an account means to make an entry on the left-hand
side of an account and to credit (cr) an account means to make an entry on
the right-hand side. The words debit and credit have no other meaning in
accounting, though in common parlance; debit has a negative connotation,
while credit has a positive connotation.

Double entry system of recording business transactions is

m
universally followed. In this system for each transaction the debit amount

co
must equal the credit amount. If not, the recording of transactions is
incorrect. The equality of debits and credits is maintained in accounting
s.
simply by specifying that the left side of asset accounts is to be used for
bu
recording increases and the right side to be used for recording decreases;
the right side of a liability and capital accounts is to be used to record
la

increases and the left side to be used for recording decreases. The account
balances when they are totaled, will then conform to the two equations:
yl
lls

1. Assets = liabilities + owners equity


2. Debits = credits
.a
w

From the above arrangement we can state that the rules of debits
w

and credits are as follows:


w

Debit Signifies Credit Signifies


1. Increase in asset accounts 1. Decrease in asset accounts
2. Decrease in liability accounts 2. increase in liability accounts
3. Decrease in owners equity accounts 3.increase in owners equity
accounts

From the rule that credit signifies increase in owners equity and
debit signifies decrease in it, the rules of revenue accounts and expense
accounts can be derived. While explaining the dual aspect of the concept
in the preceding lesson, we have seen that revenues increase the owners
equity as they belong to the owners. Since owners equity accounts increase

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on the credit side, revenue must be credits. So, if the revenue accounts are
to be increased they must be credited and if they are to be decreased they
must be debited. Similarly we have seen that expenses decrease the owners
equity. As owners equity account decreases on the debit side expenses
must be debits. Hence to increase the expense accounts, they must be
debited and to decrease it, they must be credited. From the above we can
arrive at the rules for revenues and expenses as follows:

Debit Signifies Credit Signifies


Increase in expenses Increase in revenues
Decrease in revenues Decrease in expenses

1.2.3.3 The Ledger

m
co
A ledger is a set of accounts. It contains all the accounts of a specific
business enterprise. It may be kept in any of the following two forms:
s.
bu
(i) bound ledger and
(ii) loose leaf ledger
la

A bound ledger is kept in the form of book which contains all the
yl

accounts. These days it is common to keep the ledger in the form of loose-
lls

leaf cards. This helps in posting transactions particularly when mechanized


system of accounting is used.
.a
w

1.2.3.4 Journal
w

When a business transaction takes place, the first record of it is


w

done in a book called journal. The journal records all the transactions of
a business in the order in which they occur. The journal may therefore
be defined as a chronological record of accounting transactions. It shows
names of accounts that are to be debited or credited, the amounts of the
debits and credits and any other additional but useful information about
the transaction. A journal does not replace but precedes the ledger. A
proforma of a journal is given in illustration 1.

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Illustration 1:
Journal

Date Particulars L.F. Debit Credit
2005 Cash a/c dr. 3
30,000 30,000
August 3 To sales a/c 9

In illustration 1 the debit entry is listed first and the debit amount
appears in the left-hand amount column; the account to be credited
appears below the debit entry and the credit amount appears in the right
hand amount column. The data in the journal entry are transferred to the
appropriate accounts in the ledger by a process known as posting. Any
entry in any account can be made only on the basis of a journal entry. The

m
column l.f. which stands for ledger folio gives the page number of accounts

co
in the ledger wherein posting for the journal entry has been made. After
all the journal entries are posted in the respective ledger accounts, each
s.
ledger account is balanced by subtracting the smaller total from the bigger
bu
total. The resultant figure may be either debit or credit balance and vice-
versa.
la

Thus the transactions are recorded first of all in the journal and
yl

then they are posted to the ledger. Hence the journal is called the book
lls

of original or prime entry and the ledger is the book of second entry.
While the journal records transactions in a chronological order, the ledger
.a

records transactions in an analytical order.


w
w

1.2.3.5 The Trial Balance


w

The trial balance is simply a list of the account names and their
balance as of a given moment of time with debit balances in one column
and credit balances in another column. It is prepared to ensure that the
mechanics of the recording and posting of the transaction have been
carried out accurately. If the recording and posting have been accurate
then the debit total and credit total in the trial balance must tally thereby
evidencing that an equality of debits and credits has been maintained.
In this connection it is but proper to caution that mere agreement of the
debt and credit total in the trial balance is not conclusive proof of correct
recording and posting. There are many errors which may not affect the
agreement of trial balance like total omission of a transaction, posting the

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right amount on the right side but of a wrong account etc.

The points which we have discussed so far can very well be explained
with the help of the following simple illustration.

Illustration 2:

January 1 - started business with rs.3,000


January 2 - bought goods worth rs.2,000
January 9 - received order for half of the goods from g
January 12 - delivered the goods, g invoiced rs.1,300
January 15 - received order for remaining half of the total goods purchased
January 21 - delivered goods and received cash rs.1,200

m
January 30 - g makes payment

co
January 31 - paid salaries rs.210
- received interest rs.50
s.
Let us now analyze the transactions one by one.
bu
January 1 Started Business With Rs.3,000:
la

The two accounts involved are cash and owners equity. Cash, an asset
yl

increases and hence it has to be debited. Owners equity, a liability also


lls

increases and hence it has to be credited.


.a

January 2 Bought Goods Worth Rs.2,000:


w
w

The two accounts affected by this transaction are cash and goods
(purchases). Cash balance decreases and hence it is credited and goods on
w

hand, an asset, increases and hence it is to be debited.

January 9 Received Order For Half Of The Goods From G:

No entry is required as realization of revenue will take place only


when goods are delivered (realization concept).

January 12 Delivered The Goods, `G Invoiced Rs.1,300:

This transaction affects two accounts goods (sales) a/c and


receivables a/c. Since it is a credit transaction, receivables increase

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(asset) and hence it is to be debited. Sales decreases goods on hand and


hence goods (sales) a/c is to be credited. Since the term goods is used to
mean purchase of goods and sale of goods, to avoid confusion, purchase of
goods is simply shown as purchases a/c and sale of goods as sales a/c.

January 15 Received Order For Remaining Half Of Goods:


No entry.

January 21 Delivered Goods And Received Cash Rs.1,200:

This transaction affects cash a/c. Since cash is realized, the cash
balance will increase and hence cash account is to be debited. Since the

m
stock of goods becomes nil due to sale, sales a/c is to be credited (as asset

co
in the form of goods on hand has reduced due to sales).

January 30 - `G Makes Payment: s.


bu
Both the accounts affected by this transaction are asset accounts
la

cash and receivables. Cash balance increases and hence it is to be debited.


Receivables balance decreases and hence it is to be credited.
yl
lls

January 31 Paid Salaries Rs.210:


.a

Because of payment of salaries cash balance decreases and hence


w

cash account is to be credited. Salary is an expense and since expense


w

has the effect of reducing owners equity and as owners equity account
decreases on the debit side, expenses account is to be debited.
w

January 31 Received Interest Rs.50:

The receipt of interest increases cash balance and hence cash a/c is
to be debited. Interest being revenue which has the effect of increasing the
owners equity, it has to be credited as owners equity account increases on
the credit side.

When journal entries for the above transactions are passed, they
would be as follows:

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Journal
Date Particulars L.F. Debit Credit
Cash A/C Dr. To
Jan. 1 Capital A/C (Being 3,000 3,000
Business Started)
Purchases A/C Dr.
Jan. 2 To Cash (Being Goods 2,000 2,000
Purchased)
Receivables A/C Dr.
Jan. 12 To Sales A/C (Being 1,300 1,300
Goods Sold On Credit)
Cash A/C Dr.
To Sales A/C

m
Jan. 21 1,200 1,200
(Being Goods Sold For

co
Cash)
Cash A/C Dr.

Jan. 30
To Receivables A/C
(Being Cash Received
s. 1,300 1,300
bu
For Sale Of Goods)
Salaries A/C Dr.
la

Jan. 31 To Cash A/C 210 210


yl

(Being Salaries Paid)


lls

Cash A/C Dr.


To Interest A/C
Jan. 31 50 50
.a

(Being Interest
Received)
w

Now the above journal entries are posted into respective ledger accounts
w

which in turn are balanced.


w

Cash Account
Debit Rs. Credit Rs.
To Capital A/C 3,000 By PurchasesA/C 2,000
To Sales A/C 1,200 By Salaries A/C 210
To Receivables 1,300
A/C By Balance C/D 3,340
To Interest A/C 50
5,550 5,550

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Capital Account
Debit Rs. Credit Rs.
3,000 3,000
To Balance C/D By Cash A/C
3,000 3,000

Purchases Account
Debit Rs. Credit Rs.
2,000 2,000
To Cash A/C By Balance C/D
2,000 2,000

Receivables Account
Debit Rs. Credit Rs.
1,300 1,300

m
To Balance C/D By Cash A/C
1,300 1,300

co
Sales Account
Debit Rs. Credit
s. Rs.
1,300
bu
By Receivables
2,500
To Balance C/D A/C
1,200
By Cash A/C
la

2,500 2,500
yl

Salaries Account
lls

Debit Rs. Credit Rs.


210 210
.a

To Cash A/C By Balance C/D


210 210
w

Interest Account
w

Debit Rs. Credit Rs.


w

To Balance C/D 50 50
By Cash A/C
50 50

Now A Trial Balance Can Be Prepared And When Prepared It Would Appear
As Follows:
Trial Balance
Debit Rs. Credit Rs.
Cash 3,340 Capital 3,000
Purchases 2,000 Sales 2,500
Salaries 210 Interest 50
5,550 5,550

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1.2.3.6 Closing Entries

Periodically, usually at the end of the accounting period, all revenue


and expense account balances are transferred to an account called income
summary or profit and loss account and are then said to be closed. (a detailed
discussion on profit and loss account can be had in a subsequent lesson). The
balance in the profit and loss account, which is the net income or net loss
for the period, is then transferred to the capital account and thus the profit
and loss account is also closed. In the case of corporation the net income or
net loss is transferred to retained earnings account which is a part of owners
equity. The entries which are passed for transferring these accounts are called
as closing entries. Because of this periodic closing of revenue and expense
accounts, they are called as temporary or nominal accounts. On the other
hand, the assets, liabilities and owners equity accounts, the balances of which
are shown on the balance sheet and are carried forward from year to year are
called as permanent or real accounts.

m
co
The principle of framing a closing entry is very simple. If an account
is having a debit balance, then it is credited and the profit and loss account
is debited. Similarly if a particular account is having a credit balance, it is
s.
closed by debiting it and crediting the profit and loss account. In our example
sales account and interest account are revenues, and purchases account and
bu
salaries account are expenses. Purchases account is an expense because the
entire goods have been sold out in the accounting period itself and hence they
la

become cost of goods sold out. This aspect would become more clear when the
reader proceeds to the lessons on profit and loss account. The closing entries
yl

would appear as follows:


lls

Journal
P articulars L.F. Debit Credit
.a

Profit And Loss a/c


w

Dr. 210
1 2,210
w

To Salaries A/C 2,000


To Salaries A/C
w

Sales A/C Dr.


2
To Profit And Loss 2,500 2,500
A/C
Interest A/C
Dr.
3 50 50
To Profit And Loss
A/C

Now profit and loss a/c, retained earnings a/c and balance sheet can be
prepared
which would appear as follows:

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Profit And Loss Account


Debit Rs. Credit Rs.
Purchases A/C
Salaries A/C 2,000
R e t a i n e d 210 Sales 2,500
Interest 50
Earnings A/C
340

2,550 5,550

Retained Earnings Account


Debit Rs. Credit Rs.

m
Profit And Loss
Balance 340 340
A/C

co
340 340

Balance Sheet s.
bu
Liabilities Rs. Assets Rs.
Capital 3,000
la

3,340
Retained Earn- Cash
ings 340
yl

3,340 3,340
lls

1.2.3.7 Adjustment Entries


.a
w

Because of the adopting of accrual accounting, after the preparation


w

of trial balance, adjustments relating to the accounting period have


to be made in order to make the financial statements complete. These
w

adjustments are needed for transactions which have not been recorded but
which affect the financial position and operating results of the business.
They may be divided into four kinds: two in relation to revenues and the
other two in relation to expenses. The two in relation to revenues are:

(i) Unrecorded Revenues:

Income earned for the period but not received in cash. For e.g.
Interest for the last quarter of the accounting period is yet to be received
though fallen due. The adjustment entry to be passed is:

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Accrued interest a/c (Dr)


Interest a/c (Cr)

(ii) Revenues Received In Advance:

i.e. Income relating to the next period received in the current


accounting period: e.g. Rent received in advance. The adjustment entry is:

Rent a/c (dr)
Rent received in advance a/c (cr)

The two relating to expenses are:

m
(i) Unrecorded Expenses:

co
i.e. Expenses were incurred during the period but no record of them
s.
as yet has been made: e.g. Rs.500 wages earned by an employee during the
bu
period remaining to be paid. The adjustment entry would be:
la

Wages a/c (Dr)


Accrued wages a/c (Cr)
yl
lls

(ii) Prepaid Expenses:


.a

i.e., expenses relating to the subsequent period paid in advance in


w

the current accounting period. An example which is frequently cited for


w

this is insurance paid in advance. The adjustment entry would be:


w

Prepaid insurance a/c (Dr)


Insurance a/c (Cr)

In the above four cases unrecorded revenues and prepaid expenses


are assets and hence debited (as debit may signify increase in assets) and
revenues received in advance and unrecorded expenses are liabilities and
hence credited (as credit may signify increase in liabilities).
Besides the above mentioned four adjustments, some more are to be done
before preparing the financial statements. They are:

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1. Inventory at the end


2. Provision of depreciation
3. Provision for bad debts
4. Provision for discount on receivables and payables
5. Interest on capital and drawings

1.2.3.8 Preparation Of Financial Statements

Now everything is set ready for the preparation of financial


statements for the accounting period and as of the last day of the accounting
period. Generally agreed accounting principles (gaap) require that three
such reports be prepared:

m
(i) a balance sheet

co
(ii) a profit and loss account (or) income statement
(iii) a fund flow statement
s.
bu
A detailed discussion on these three financial statements follows in the
succeeding lessons.
la
yl

1.2.3.9 Introduction To Tally Package


lls

Today an increasingly large number of companies have adopted


.a

mechanized accounting. The main reasons for this development are that:
w
w

(i) the size of firms have become very large resulting in manifold increase
in accounting data to be collected and processed.
w

(ii) the requirements of modern management which want detailed analysis


in many ways, of the accounting and statistical information for the efficient
discharge of their duties.

(iii) collection of statistics not only for the firms own use but also for
submission to various official authorities.

In this context, the use of computers in accounting is worth


mentioning. Late 80s and early 90s was an era of financial accounting
software. Many software developers offered separate financial and

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inventory software to take care of the needs of the concerns but users
wanted a single software that will take care of production and inventory
management i.e. They wanted a single software where, if an invoice is
entered, that will update accounts as well as inventory information. Here
tally comes in handy.

Tally is one of the acclaimed accounting software with large user


base in india and abroad, which is continuously growing. There is good
potential for tally professionals even in small towns. Tally which is a vast
software covers a lot of areas for various types of industries and is loaded
with options. So, every organization needs a hardcore tally professional to
exploit its full capabilities and functionality to implement tally. Tally which
is a financial and inventory management system is developed in india

m
using tally development language. Tally has been created by pentronics (p)

co
limited, bangalore.

Features Of Tally: s.
bu
1. Accounts without any account codes.
la

2. Maintains complete range of books of accounts, final accounts like


balance sheets, profit and loss statements, cash and fund flows, trial
yl

balance and others.


lls

3. Provides option to post stock value from inventory directly to balance


sheet and profit and loss a/c as per the valuation method specified
.a

by user. This greatly simplifies the procedure and one gets the final
w

accounts which is in tune with the stock statements of the inventory


w

system.
4. Provides multiple reports in diverse formats.
w

5. Various options for interest calculation.


6. Allows accounts of multiple companies simultaneously.
7. Multiple currencies in the same transactions and viewing all reports
in one or more currency.
8. Unlimited budgets and periods, user definable security levels for
access control and audit capabilities to track malafide changes.
9. Allows import and export of data from or to other systems.
10. Online help.
11. Backup and restore of data.
12. Facilitates printing of cheques etc.

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1.2.3.10 Summary

The following steps are involved in the accounting process:

1. The first and the most important part of the accounting process
is the analysis of the transactions to decide which account is to be
debited and which account is to be credited.
2. Next comes journalising the transactions i.e. Recording the
transactions in the journal.
3. The journal entries are posted into respective accounts in the ledger
and the ledger accounts are balanced.
4. At the end of the accounting period, a trial balance is prepared to
ensure quality of debits and credits.

m
5. Adjustment and closing entries are made to enable the preparation

co
of financial statements.
6. As a last step financial statements are prepared.


s.
These six steps taken sequentially complete the accounting process
bu
during an accounting period and are repeated in each subsequent period.
la

1.2.3.11 Key Words


yl
lls

Account: a statement wherein information relating to all items are


.a

accumulated.
w

Debit: signifies increase in asset accounts, decrease in liability


w

accounts and decrease in owners equity accounts.


w

Credit: signifies decrease in asset accounts, increase in liability


accounts and increase in owners equity accounts.

Ledger: a set of accounts of a specific business enterprise.


Journal: a book of prime entry.

Trial Balance: a list of balances of accounts to ensure arithmetical


accuracy.

Closing Entries: entries passed to transfer the revenue accounts to profit


and loss a/c.

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Adjustment Entries: entries passed for transactions which are not recorded
but which affect the financial position and operating results of the business.

1.2.3.12 Self Assessment Questions

1. Explain the following:


(a) a journal
(b) an account
(c) a ledger
2. Bring out the relationship between a journal and a ledger.
3. Explain the significance of trial balance.
4. Why are adjustment entries necessary?
5. Narrate the rules of debit and credit.

m
6. Distinguish nominal accounts from real accounts.

co
7. Explain the mechanism of balancing an account.
8. How and why closing entries are made?
s.
9. The following transactions relate to a business concern for the
bu
month of december 2005. Journalise them, post into ledger accounts,
balance and prepare the trial balance.
la

March 1 - started business with a capital of rs.9,000


yl

March 2 - purchased furniture for rs.300


lls

March 3 - purchased goods for rs.6,000


March 11 - received order for half-of the goods from `c
.a

March 15 - delivered goods, `c invoiced rs.4,000


w

March 17 - received order for the remaining half of the goods


w

March 21 - delivered goods, cash received rs.3,800


March 31 - paid wages of rs.300
w

1.2.3.13 Books For Further Reading

1. M.A.Arulanandam & K.S.Raman: Advanced Accounts, Himalaya


Publishing House.
2. R.L.Gupta And M.Radhaswamy: Advanced Accounts, Vol.I, Sultan
Chand, New Delhi.
3. M.C.Shukla And T.S.Grewal: Advanced Accounts, S.Chand & Co. New
Delhi.

*****

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Lesson 1.3 - Preparation of Final Accounts

1.3.1 Introduction

The primary objective of any business concern is to earn income.


Ascertainment of the periodic income of a business enterprise is perhaps the
important objective of the accounting process. This objective is achieved
by the preparation of profit and loss account or the income statement.
Profit and loss account is generally considered to be of greatest interest and
importance to end users of accounting information. The profit and loss

m
account enables all concerned to find out whether the business operations

co
have been profitable or not during a particular period. Usually the profit
and loss account is accompanied by the balance sheet as on the last date of
s.
the accounting period for which the profit and loss account is prepared. A
bu
balance sheet shows the financial position of a business enterprise as of a
specified moment of time. It contains a list of the assets, the liabilities and
la

the capital of a business entity as of a specified date, usually at the close


of the last day of a month or a year. While the profit and loss account is
yl

categorized as a flow report (for a particular period), the balance sheet is


lls

categorized as a status report (as on a particular date).


.a

1.3.2 Learning Objectives


w
w

After reading this lesson the reader should be able to:


w

Understand the Basic Ideas of Income and Expense


Prepare a Profit and Loss Account/Income Statement in the
Proper Format
Understand the Basic Ideas About a Balance Sheet
Classify the Different Assets and Liabilities
Prepare a Balance Sheet in the Proper Format

1.3.3 Contents

1.3.3.1 basic ideas about income and expense


1.3.3.2 form and presentation of profit and loss account /

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Income statement
1.3.3.3 explanation of items on the income statement
1.3.3.4 statement of retained earnings
1.3.3.5 balance sheet
1.3.3.6 form and presentation of balance sheet
1.3.3.7 listing of items in the balance sheet
1.3.3.8 classification of items in the balance sheet
1.3.3.9 summary
1.3.3.10 key words
1.3.3.11 self assessment questions
1.3.3.12 key to self assessment questions
1.3.3.13 case analysis
1.3.3.14 book for further reading

m
co
1.3.3.1 Basic Ideas About Income And Expense

s.
Profit and loss account consists of two elements: one element is the
bu
inflows that result from the sale of goods and services to customers which
are called as revenues. The other element reports the outflows that were
la

made in order to generate those revenues; these are called as expenses.


Income is the amount by which revenues exceed expenses. The term
yl

net income is used to indicate the excess of all the revenues over all the
lls

expenses. The basic equation is:


.a

Revenue Expenses = Net Income


w
w

This is in accordance with the matching concept.


w

Income And Owners Equity:

The net income of an accounting period increases owners equity


because it belongs to the owner. To quote an example, goods costing
rs.20,000 are sold on credit for rs.28,000. The result is that stock is reduced
by rs.20,000 and a new asset namely debtor for rs.28,000 is created and
the total assets increase by the difference of rs.8,000. Because of the dual
aspect concept, we know that the equity side of the balance sheet would
also increase by rs.8,000 and the increase would be in owners equity. This
is because the profit on sale of goods belongs to the owner. It is clear from
the above example that income increases the owners equity.

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Income Vs. Receipts:

Income of a period increases the owners equity but it need not


result in increase in cash balance. Loss of a period decreases owners equity
but it need not result in decrease in cash balance. Similarly, increase in
cash balance need not result in increased income and owners equity and
decrease in cash balance need not denote loss and decrease in owners
equity. All these are due to the fact that income is not the same as cash
receipt. The following examples make clear the above point:
I) when goods costing rs.20,000 are sold on credit for rs.28,000 it results in
an income of rs.8,000 but the cash balance does not increase.
Ii) when goods costing rs.18,000 are sold on credit for rs.15,000 there is a
loss of rs.3,000 but there is no corresponding decrease in cash.

m
Iii) when a loan of rs.5,000 is borrowed the cash balance increases but

co
there is no impact on income.
Iv) when a loan of rs.8,000 is repaid it decreases only the cash balance and
not the income. s.
bu
Expenses:
la

An expense is an item of cost applicable to an accounting period.


yl

It represents economic resources consumed during the current period.


lls

When expenditure is incurred the cost involved is either an asset or an


expense. If the benefits of the expenditure relate to further periods, it is
.a

an asset. If not, it is an expense of the current period. Over the entire


w

life of an enterprise, most expenditure becomes expenses. But according


w

to accounting period concept, accounts are prepared for each accounting


period. Hence, we get the following four types of transactions relating to
w

expenditure and expenses:

Expenditures That Are Also Expenses:

This is the simplest and most common type of transaction to


account for. If an item is acquired during the year, it is expenditure. If the
item is consumed in the same year, then the expenditure becomes expense.
E.g. Raw materials purchased are converted into saleable goods and are
sold in the same year.

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Assets That Become Expenses:

when expenditures incurred result in benefits for the future period


they become assets. When such assets are used in subsequent years they
become expenses of the year in which they are used. For e.g. Inventory of
finished goods are assets at the end of a particular accounting year. When
they are sold in the next accounting year they become expenses.

Expenditures That Are Not Expenses:

As already pointed, out when the benefits of the expenditure relate


to future periods they become assets and not expenses. This applies not
only to fixed assets but also to inventories which remain unsold at the end

m
of the accounting year. For e.g. The expenditure incurred on inventory

co
remaining unsold is asset until it is sold out.

Expenses Not Yet Paid: s.


bu
Some expenses would have been incurred in the accounting year
la

but payment for the same would not have been made within the accounting
year. These are called accrued expenses and are shown as liabilities at the
yl

year end.
lls

1.3.3.2 Form And Presentation Of Profit And Loss Account / Income


.a

Statement
w
w

In practice there is considerable variety in the format and degree


of detail used in income statements. The profit and loss account is usually
w

prepared in t shape. The following (illustration-a) is the summarized


profit and loss account of ali akbar ltd.

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Illustration A:
Ali Akbar Ltd
Profit And Loss Account For The Year Ended 31st March 2005
(rs. In `000)

Particulars Rs. Particulars Rs.


Cost Of Goods Sold 78.680 Sales(Less Dis count) 89,740
Expenses (Schedule17) 33,804 Other Income (Sched- 39,947
Interest (Schedule 18) 2,902 ule 13)
Directors Fees 11
Depreciation 20,94
Provision For Taxation 6,565
Net Profit 5,,625

m
1,29,687 1,29,687

co
In the t shaped profit and loss account, expenses are shown on

s.
the left hand side i.e., the debit side and revenues are shown on the right
bu
hand side i.e., the credit side. Net profit or loss is the balancing figure.
la

The profit and loss account can also be presented in the form of a
statement when it is called as income statement. There are two widely used
yl

forms of income statement: single step form and multiple-step form. The
lls

single-step form of income statement derives its name from the fact that
the total of all expenses is deducted from the total of all revenues.
.a
w

Illustration a can be presented in the single-step form as given in


illustration b.
w
w

Illustration B:
Ali Akbar Ltd
Income Statement For The Year Ended 31st March 2005
(Rs. In `000)
Revenues
Sales (Less Discount) 89,740
Other Income (Sched-
ule 13) 39,947 1,29,687

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Expenses
Cost Of Goods Sold 78.680
Expenses (Schedule 17) 33,804
Interest (Schedule 18) 2,902
Directors Fees 11
Depreciation 20,94
Provision For Taxation 6,565 1,24,062

5,625

The single-step form has the advantage of simplicity but it is


inadequate for analytical purpose.
The multi-step form income statement is so called because of its
numerous sections, sub-sections and intermediate balances. Illustration

m
c is a typical proforma of multiple-step income statement.

co
Illustration C:

s.
Proforma Of A Multiple-Step Income Statement
bu
la

Gross Sales Xxx


yl

Less: Sales Returns Xxx


Net Sales Xxx
lls

Less: Cost Of Goods Sold


Raw Materials Cost
.a

Opening Stock Of Raw Material Xxx


Add Purchase Of Raw Material Xxx
w

Freight Xxx
w

Raw Materials Available Xxx


Less Closing Stock Of Raw Material Xxx
w

Raw Materials Consumed Xxx


Direct Labour Cost Xxx
Manufacturing Expenses Xxx
Total Production Cost Xxx
Add Opening Work-In-Progress Xxx
Total Xxx
Less Closing Work-In-Progress Xxx

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Cost Of Goods Manufactured Xxx


Add Opening Finished Goods Xxx
Cost Of Goods Available For Sale Xxx
Less Closing Finished Goods Xxx
Xxx
Cost Of Goods Sold
Gross Profit Xxx
Less Operating Expenses Xxx
Administrative Expenses
Selling And Distribution Expenses Xxx
Operating Profit Xxx Xxx
Xxx
Add Non-Operating Income
(Such As Dividend Received
Profit On Sale Of Assets Etc.)
Xxx Xxx
Less Non-Operating Expenses

m
(Such As Discount On Issue Of Shares

co
Written Off, Loss On Sale Of Assets, Etc.) Xxx Xxx
Profit (Or) Earnings Before Interest & Tax (Ebit) Xxx
Less Interest
Profit (Or) Earnings Before Tax (Ebt) s.
Xxx
Xxx
Xxx
bu
Less Provision For Income-Tax Xxx Xxx
Net Profit (Or) Earnings After Tax (Eat) Xxx
Earnings Per Share Of Common Stock Xxx Xxx
la
yl
lls

The Multiple-Step Form Of Illustration `C Would Be As Given Under


Illustration `D.
.a
w
w
w

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Illustration D

Ali Akbar Ltd


Income Statement For The Year Ended 31st March 2005
(rs. In `000)

Net Sales 98,740


Less: Cost Of Goods Sold 78,686
Gross Profit 11,054
Less Operating Expenses
Expenses (Schedule 17)
33,804
Directors Fee
11
Depreciation
2,094 35,909
Operating Loss

m
(-) 24,855
Add Non-Operating Income

co
Other Income (Schedule 13) 39,947
Profit (Or) Earnings Before Interest & Tax(Ebit) 15,092
Less Interest (Schedule 18)
Profit (Or) Earnings Before Tax (Ebt) s. 2,902
12,190
bu
Less Provision For Income-Tax 6,565
Net Profit (Or) Earnings After Tax (Eat) 5,625
la
yl


lls

The advantage of multiple-step form of income statement over


single step form and the t shaped profit and loss account is that there are
.a

a number of significant sub totals on the road to net income which lend
themselves for significant analysis.
w

Income statements prepared for use by the managers of an enterprise


w

Usually contain more detailed information than that shown in the above
w

illustrations.

1.3.3.3 Explanation Of Items On The Income Stataement

The heading of the income statement must show:

I) the business enterprise to which it relates (ali akbar ltd.)


Ii) the name of the statement (income statement)
Iii) the time period covered (year ended 31st march of the relevant
year)

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The income statement is generally followed by various schedules that give


detailed account of the items, listed on them. Information about these
schedules are given against each item in the financial statements.

One important objective in reporting revenue on an income


statement is to disclose the major source of revenue and to separate it from
miscellaneous sources. For most companies the major source of revenue is
the sale of goods and services.

Sales Revenue:

An income statement often reports several separate items in the


sales revenue section, the net of which is the net sales figure. Gross sales

m
is the total invoice price of the goods sold or services rendered during

co
the period. It should not include sales taxes or excise duties that may be
charged to the customers. Such taxes are not revenues but rather represent
s.
collections that the business makes on behalf of the government and are
bu
liabilities to the government until paid. Similarly, postage, freight or other
items billed to the customers at cost are not revenues. These items do not
la

appear in the sales figure but instead are an offset to the costs the company
incurs for them. Sales returns and allowances represent the sales values of
yl

goods that were returned by customers or allowance made to customers


lls

because the goods were defective. The amount can be subtracted from the
sales figure directly without showing it as a separate item on the income
.a

statement. But it is always better to show them separately.


w
w

Sometimes called as cash discounts, sales discounts are the amount


of discounts allowed to customers for prompt payment. For e.g. If a
w

business offers a 3% discount to customers who pay within 7 days from


the date of the invoice and it sells rs.30,000 of goods to a customer who
takes advantage of this discount, the business receives only rs.29,100 in
cash and records the balance rs.900 as sales discount. There is another
kind of discount called as trade discount which is given by the wholesaler
or manufacturer to the retailers to enable them to sell at catalogue price
and make a profit: e.g. List less 30 percent. Trade discount does not appear
in the accounting records at all.

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Miscellaneous Or Secondary Sources Of Revenues:

These are revenues earned from activities not associated with the
sale of the enterprises goods and services. Interest or dividends earned
on marketable securities, royalties, rents and gains on disposal of assets
are examples of this type of revenues. For e.g. In the case of ali akbar ltd.,
its operating loss has been converted into net profit only because of other
income, other than sales revenue. Schedule 13 gives details of other income
earned by ali akbar ltd.

Schedule 13 Other Income


(rs.`000)
Income From Trade Investments 825

m
Interest On Bank Deposits & Others 1,042
Profit On Sale Of Investments 456

co
Profit On Sale Of Inventories 813
Miscellaneous Income 2,394
Factory Charges Recovered
Bottle Deposits Forfeited
s. 9,081
25,336
bu
39,947
la
yl

Cost Of Goods Sold:


lls

when income is increased by the sale value of goods or services


.a

sold, it is also decreased by the cost of these goods or services. The cost
of goods or services sold is called the cost of sales. In manufacturing
w

firms and retailing business it is often called the cost of goods sold. The
w

complexity of calculation of cost of goods sold varies depending upon the


w

nature of the business. In the case of a trading concern which deals in


commodities it is very simple to calculate the most of goods sold and it is
done as follows:

Opening stock xxx


Add: purchase xxx
Freight xxx

Goods available for sale xxx


Less: closing stock xxx
Cost of goods sold xxx

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The calculation becomes a complicated process in the case of


manufacturing concern, especially when a number of products are
manufactured because it involves the calculation of the work in progress
and valuation of inventory. The cost of goods sold in the case of ali akbar
ltd., would have been calculated as given in illustration `e.

Illustration E:

Cost Of Goods Sold


(rs.`000)
Opening Stock 4,436
Raw Materials Consumed 22,151
Packing Materials Consumed 48,536

m
Excise Duty 7,805
82,928

co
Less: Closing Stock 4,242

Cost Of Goods Sold


s.
78,686
bu
Gross Profit:
la

The excess of sales revenue over cost of goods sold is gross margin
yl

or gross profit. In the case of multiple-step income statement it is shown


lls

as a separate item. Significant managerial decisions can be taken by


calculating the percentage of gross profit on sale. This percentage indicates
.a

the average mark up obtained on products sold. The percentage varies


w

widely among industries, but healthy companies in the same industry tend
to have similar gross profit percentages.
w
w

Operating Expenses:

Expenses which are incurred for running the business and which
are not directly related to the companys production or trading are
collectively called as operating expenses. Usually operating expenses
include administration expenses, finance expenses, depreciation and
selling and distribution expenses. Administration expenses generally
include personnel expenses also. However sometimes personnel expenses
may be shown separately under the heading establishment expenses.
Until recently most companies included expenses on research and
development as part of general and administrative expenses. But now-

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a-days the financial accounting standards board (fasb) requires that this
amount should be shown separately. This is so because the expenditure
on research and development could provide an important clue as to how
cautious the company is in keeping its products and services up to date.
Operating Profit: operating profit is obtained when operating expenses are
deducted from gross profit.

Non-Operating Expenses:

These are expenses which are not related to the activities of the
business e.g. Loss on sale of asset, discount on shares written off etc.
These expenses are deducted from the income obtained after adding other
incomes to the operating profit. Other incomes or miscellaneous receipts

m
have already been explained. The resultant profit is called as profit (or)

co
earning before interest and tax (ebit).

Interest Expenses: s.
bu
Interest expense arises when part of the expenses are met from
la

borrowed funds. The fasb requires separate disclosure of interest expense.


This item of expense is deducted from income or earnings before interest
yl

and tax. The resultant figure is profit (or) earnings before tax (ebt).
lls

Income Tax: the provision for tax is estimated based on the quantum of
profit before tax. As per the corporate tax laws, the amount of tax payable
.a

is determined not on the basis of reported net profit but the net profit
w

arrived at has to be recomputed and adjusted for determining the tax


w

liability. That is why the liability is always shown as a provision.


w

Net Profit:

This is the amount of profit finally available to the enterprise for


Appropriation. Net profits is reported not only in total but also per
share of stock. This per share amount is obtained by dividing the total
amount of net profit by the number of shares outstanding. The net profit
is usually referred to as profit or earnings after tax. This profit could either
be distributed as dividends to shareholders or retained in the business.
Just like gross profit percentage, net profit percentage on sales can also be
calculated which will be of great use for managerial analysis.

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1.3.3.4 Statement Of Retained Earnings

The term retained earnings means the accumulated excess of


earnings over losses and dividends. The statement of retained earnings
is generally included with almost any set of financial statements although
it is not considered to be one of the major financial statements. A typical
statement of retained earnings starts with the opening balance of retained
earnings, the net income for the period as an addition, the dividends as
a deduction, and ends with the closing balance of retained earnings. The
statement may be prepared and shown on a separate sheet or included at
the bottom of the income statement. The balance shown by the income
statement is transferred to the balance sheet through the statement of
retained earnings after making necessary appropriations. This statement

m
thus links the income statement to the retained earning item on the balance

co
sheet. This statement can be prepared in `t shape also when it is called as
profit and loss appropriation account. Illustration `f gives the statement
of retained earning of ali akbar ltd. s.
bu
Illustration F Ali Akbar Ltd.
la

For The Year Ended 31st March 2012


yl

(Rs.`000)
lls

Retained Earnings At The Beginning Of 700


The Year 5,625
.a

Add: Net Income 6,325


w

Less: Dividends 5,600


w

General Reserve 625 6,225


w

Retained Earnings At The End Of The Year 100

1.3.3.5 Balance Sheet

The balance sheet is basically a historical report showing the


cumulative effect of past transactions. It is often described as a detailed
expression of the following fundamental accounting equation:
Assets = Liabilities + Owners Equity (Capital)
Assets are costs which represent expected future economic benefits to the
business enterprise. However, the rights to assets have been acquired by
the Enterprise as a result of past transactions.

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Liabilities also result from past transactions. They represent


obligations which require settlement in the future either by conveying
assets or by performing services. Implicit in these concepts of the nature
of assets and liabilities is the meaning of owners equity as the residual
interest in the assets of the enterprise.

1.3.3.6 Form And Presentation Of A Balance Sheet

Two objectives are dominant in presenting information in a balance


sheet. One is clarity and readability; the other is disclosure of significant
facts within the framework of the basic assumptions of accounting. Balance
sheet classification, terminology and the general form of presentation
should be studied with these objectives in mind.

m
It is proposed to explain the various aspects of the balance sheet with the

co
help of the following typical summarized balance sheet of an imaginary
Partnership firm:
s.
bu
la
yl
lls
.a
w
w
w

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Illustration A:

Sundaram & Sons


Balance Sheet As At 31st December 2011

Liabilities & Rs Rs Assets Rs Rs


Capital
Current Liabilities Current Assets
Bills Payable 7,000 Cash 1.000
Creditors 7,000 Bank 2,000
Outstanding Marketable
Expenses Securities 3,000
Income Received 7,000 Bills Receivables 3,000
In Advance Debtors 10,000

m
Provision For 1,000 Less Provision
Income 32,000 For Doubtful

co
Tax 10,000 Debts 1,000 9,000
Total Current Inventory 12,000
Liabilities
Long Term
Prepaid
Expenses s. 3,000
33,000
bu
Liabilities Total Current
Mortgage Loan 20,000 Assets
Owners Equity Investments:
la

Ss Capital 10,000 Long Term


yl

As Capital 15,000 Securities


Us Capital 20,000 AtCosts 3,000
lls

General Reserve 10,000 Fixed Assets:


Furniture &
.a

Fixtures Less:
Accumulated
w

Dep. Plant &


w

Machinery 900
Less:
w

Accumulated
Dep. 1,000 8,000
Land 100 20,000
Buildings
Intangible Assets 10,000
Patents 2,100
Trade Marks 2,000 11,000
Goodwill 9,000
Total Assets 1,07,000 Total Liabilities 1,07.000
& Owners
Equity

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Conventions Of Preparing The Balance Sheet:

There are two conventions of preparing the balance sheet, the


american and the english. According to the american convention, assets
are shown on the left hand side and the liabilities and the owners equity
on the right hand side. Under the english convention just the opposite is
followed i.e. Assets are shown on the right hand side and the liabilities and
owners equity are shown on the left hand side. In the illustration `a, the
american convention has been followed.

Forms Of Presenting The Balance Sheet:

There are two forms of presenting the balance sheet account

m
form and report form. When the assets are listed on the left hand side and

co
liabilities and owners equity on the right hand side, we get the account
form of balance sheet. It is so called because it is similar to an account. An
s.
alternative practice is the report form of balance sheet where the assets
bu
are listed at the top of the page and the liabilities and owners equity are
listed beneath them. In illustration `a we have followed the account form
la

of balance sheet. Now-a-days joint stock companies present balance sheet


in the form of a statement in the annual reports. To illustrate, the balance
yl

sheet of ali akbar ltd. Pondicherry as on 31-3-2012 is given below:


lls
.a
w
w
w

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Illustration `b:
Ali akbar ltd.Balance sheet as on 31-3-2012
2004-05 2005-06
Rs. 000 Rs. 000
Sche-
dule
I. Sources of Funds
1. Shareholders Funds
Capital 1 1,40,00 1,40,00
Reserves And Surplus 2 12,11,94 12,73,93
2. Loan Funds
Secured Loans 3 2,45,15 2,67,62
Unsecured Loans 4 24
15,97,09 16,81,79
Ii. Application of

m
Funds

co
1. Fixed Assets
5 14,19,93 13,73,59
Gross Block
4,64,56 3,81,38
Less: Depreciation
9,55,37 s.
9,92,21
bu
Net Block
16,27
Capital Work-In-
Progress
la

2. Investments
6 9,55,37 10,08,48
3. Current Assets
yl

76,39 63,07
Loans And Advances
lls

Inventories
2,37,55
Sundry Debtors
1,55,71 3,16,52
.a

Cash And Bank


7 3,59,65 74,55
Balances
8 69,52 2,11,60
w

Loans And Advances


9 2,22,03 8,40,22
Less: Current
w

10 8,06,91
Liabilities &
w

Provisions
1,74,77
Liabilities
1,85,58 55,21
Provisions
11 56,00
12 2,29,98
Net Current Assets 2,41,58

5,65,33 6,10,24
15,97,09 16,81,79

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Notes On The Accounts:

Schedules 1 to 12 and 19 referred to above, form an integral part of


the balance sheet.

From the above balance sheet it would have been found that previous
years figures are also given. As per the companies act, 1956 it is mandatory
for the companies to give figures for the previous year also. Further one
would have noticed the schedule column in the above balance sheet. The
schedules attached to the balance sheet give details of the respective items.
For e.g. Schedule 3 gives details of the secured loan as given below:

Schedule 3 Secured Loans Rs. 000

m
co
From banker 2004-05 2003-04
Term loan (secured by charge on certain 17,00 28,00
Plant & machinery) s.
bu
Cash credit-account (secured by hypothecation 2,28,15 2,39,62
Of raw materials, stock-in-progress, finished
la

Goods, stocks and other current assets) 2,45,15 2,67,62


yl
lls

1.3.3.7 Listing Of Items On The Balance Sheet


.a

Assets in balance sheet are generally listed in two ways i) in the


w

order of liquidity or according to time i.e. In the order of the degree of


w

ease with which they can be converted into cash or ii) in the order of
permanence or according to purpose i.e., in the order of the desire to keep
w

them in use. Some assets cannot be easily classified. For e.g. Investments
can be easily sold but the desire may be to keep them. Investments may
therefore be both liquid and semi-permanent that is why they are shown
as a separate item in the balance sheet. Liabilities can also be grouped in
two ways; either in the order of urgency of payment or in the reverse order.
The various assets and liabilities grouped in the two orders will appear as
follows:

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Order Of Liquidity

Liabilities Assets
Bank Overdraft Cash
Bills Payable Bank
Creditors Marketable Securities
Outstanding Expenses Debtors
Income Received In Advance Inventory
Provision For Income-Tax Bills Receivable
Mortgage Loan Prepaid Expenses
Debentures Investments
Owners Equity Furniture And Fixtures
Plant And Machinery
Land And Buildings
Patents

m
Trade Marks
Goodwill

co
Preliminary Expenses

s.
bu
Order Of Permanence
la

Liabilities Assets
Owners Equity Goodwill
yl

Debentures Trade Marks


Mortgage Loan Patents
lls

Provision For Income-Tax Land And Buildings


Income Received In Advance Plant And Machinery
.a

Outstanding Expenses Furniture And Fixtures


w

Creditors Investments
Bills Payable Prepaid Expenses
w

Inventory
Debtors
w

Marketable Securities
Bank
Cash
Bills Receivables

Whatever is the order, it is always better to follow the same order


for both assets and liabilities. In the illustration `a the order of liquidity
has been followed.

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1.3.3.8 Classification Of Items In The Balance Sheet

Although each individual asset or liability can be listed separately


on the balance sheet, it is more practicable and more informative to
summarize and group related items into categories called as account
classifications. The classifications or group headings will vary considerably
depending on the size of the business, the form of ownership, the nature
of its operations and the users of the financial statements. For e.g. While
listing assets, the order of liquidity is generally used by sole traders,
partnership firms and banks, whereas joint stock companies by law follow
the order of permanence. As a generalization which is subject to many
exceptions, the following classification of balance sheet items is suggested
as representative:

m
co
Assets
Current assets
Investments s.
bu
Fixed assets
Intangible assets
la

Other assets
yl

Liabilities
lls

Current liabilities
Long term liabilities
.a
w

Owners Equity
w

Capital
Retained earnings
w

Classification Of Assets

Consumed Current Assets:

Current assets are those which are reasonably expected to be


realized in cash or sold or consumed during the normal operating cycle
of the business enterprise or within one year, whichever is longer. By
operating cycle we mean the average period of time between the purchase
of goods or raw materials and the realisation of cash from the sale of goods
or the sale of products produced with the help of raw materials. Current

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assets generally consist of cash, marketable securities, bills receivables,


debtors, inventory and prepaid expenses.

Cash:

Cash consists of funds that are readily available for


disbursement. It includes cash kept in the cash chest of the enterprise as
also cash deposited on call or current accounts with banks.

Marketable Securities:

These consist of investments that are both readily marketable


and are expected to be converted into cash within a year. These investments

m
are made with a view to earn some return on cash that otherwise would be

co
temporarily idle.

Accounts Receivable: s.
bu
Accounts receivable consist of amounts owed to the
la

enterprise by its consumers. This represents amounts usually arising out of


normal commercial transactions. These amounts are listed in the balance
yl

sheet at the amount due less a provision for portion that may not be
lls

collected. This provision is called as provision for doubtful debts. Amounts


due to the enterprise by someone other than a consumer would appear
.a

under the heading `other receivables rather than `accounts receivables.


w

If the amounts due are evidenced by written promises to pay, they are
w

listed as bills receivables. Accounts receivables are expected to be realised


in cash.
w

Inventory:

Inventory consists of i) goods that are held in stock for sale in


the ordinary course of business, ii) work-in-progress that are to be currently
consumed in the production of goods or services to be available for sale.
Inventory is expected to be sold either for cash or on credit to customers to
be converted into cash. It may be noted in this connection that inventory
relates to goods that will be sold in the ordinary course of business. A van
offered for sale by a van dealer is inventory. A van used by the dealer to make
service calls is not inventory but an item of equipment which is a fixed asset.

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Prepaid Expenses:

These items represent expenses which are usually paid in


advance such as rent, taxes, subscriptions and insurance. For e.g. If rent for
three months for the building is paid in advance then the business acquires
a right to occupy the building for three months. This right to occupy is an
asset. Since this right will expire within a fairly short period of time it is a
current asset.

Long Term Investments:

The distinction between a marketable security shown under

m
current asset and as an investment is entirely based on time factor. Those

co
investments like investments in shares, debentures, bonds etc. That will be
retained for more than one year or one operating cycle will appear under
this classification. s.
bu
Fixed Assets:
la

Tangible assets used in the business that are of a permanent


yl

or relatively fixed nature are called plant assets or fixed assets. Fixed assets
lls

include furniture, equipment, machinery, building and land. Although


there is no standard criterion as to the minimum length of life necessary
.a

for classification as fixed assets, they must be capable of repeated use


w

and are ordinarily expected to last more than a year. However the asset
w

need not actually be used continuously or even frequently. Items of spare


equipments held for use in the event of breakdown of regular equipment
w

or for use only during peak periods of activity are also included in fixed
assets.

With the passage of time, all fixed assets with the exception of
land lose their capacity to render services. Accordingly the cost of such
assets should be transferred to the related expense amounts in a systematic
manner during their expected useful life. This periodic cost expiration is
called depreciation. While showing the fixed assets in the balance sheet
the accumulated depreciation as on the date of balance sheet, is deducted
from the respective assets.

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Intangible Assets:

While tangible assets are concrete items which have


physical existence such as buildings, machinery etc., intangible assets
are those which have no physical existence. They cannot be touched and
felt. They derive their value from the right conferred upon their owner by
possession. Examples are: goodwill, patents, copyrights and trademarks.

Fictitious Assets:

These items are not assets. Yet they appear in the asset side
simply because of a debit balance in a particular account not yet written off
e.g. Debit balance in current account of partners, profit and loss account,

m
etc.

co
Classification Of Liabilities
s.
bu
Current Liabilities:
la

When the liabilities of a business enterprise are due within


an accounting period or the operating cycle of the business, they are
yl

classified as current liabilities. Most of the current liabilities are incurred


lls

in the acquisition of materials or services forming part of the current


assets. These liabilities are expected to be satisfied either by the use of
.a

current assets or by the creation of other current liabilities. The one year
w

time interval or current operating cycle criterion applies to classifying


w

current liabilities also. Current liabilities generally consists of bills payable,


creditors, outstanding expenses, income received in advance, provision for
w

income-tax etc.

Accounts Payable:

These amounts represent the claims of suppliers related to


goods supplied or services rendered by them to the business enterprise
for which they have not yet been paid. Usually these claims are unsecured
and are not evidenced by any formal written acceptance or promise to
pay. When the enterprise gives a written promise to pay money to a
creditor for the purchase of goods or services used in the business or the
money borrowed, then the written promise is called as bills payable or

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notes payable. Amounts due to financial institutions which are suppliers


of funds, rather than of goods or services are termed as short-term loans
or by some other name that describes the nature of the debt instrument,
rather than accounts payable.

Outstanding Expenses:

These are expenses or obligations incurred in the previous


accounting period but the payment for which will be made in the next
accounting period. A typical example is wages or rent for the last month
of the accounting period remaining unpaid. It is usually paid in the first
month of the next accounting period and hence it is an outstanding
expense.

m
co
Income Received In Advance:

s.
These amounts relate to the next accounting period
bu
but received in the previous accounting period. This item of liability
is frequently found in the balance sheet of enterprises dealing in the
la

publication of newspapers and magazines.


yl

Provision For Taxes:


lls

This is the amount owed by the business enterprise to the


.a

government for taxes. It is shown separately from other current liabilities


w

both because of the size and because the amount owed may not be known
w

exactly as on the date of balance sheet. The only thing known is the
existence of liability and not the amount.
w

Long Term Liabilities:

All liabilities which do not become due for payment in


one year and which do not require current assets for their payment are
classified as long-term liabilities or fixed liabilities. Long term liabilities
may be classified as secured loans or unsecured loans. When the long-
term loans are obtained against the security of fixed assets owned by the
enterprise, they are called as secured or mortgaged loans. When any asset
is not attached to these loans they are called as unsecured loans. Usually
long-term liabilities include debentures and bonds, borrowings from

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financial institutions and banks, public debts, etc. Interest accrued on a


particular secured long term loan, should be shown under the appropriate
sub-heading.

Contingent Liabilities:

Contingent liabilities are those liabilities which may or may


not result in liability. They become liabilities only on the happening of a
certain event. Until then both the amount and the liability are uncertain.
If the event happens there is a liability; otherwise there is no liability at all.
A very good example for contingent liability is a legal suit pending against
the business enterprise for compensation. If the case is decided against the
enterprise the liability arises and in the case of favourable decision there is

m
no liability at all. Contingent liabilities are not taken into account for the

co
purpose of totaling of balance sheet.

Capital Or Owners Equity: s.


bu
As mentioned earlier, owners equity is the residual interest
la

in the assets of the enterprise. Therefore the owners equity section of the
balance sheet shows the amount the owners have invested in the entity.
yl

However, the terminology `owners equity, varies with different forms


lls

of organisations depending upon whether the enterprise is a joint stock


company or sole proprietorship / partnership concern.
.a
w
w

Sole Proprietorship / Partnership Concern:


w

The ownership equity in a sole


Proprietorship or partnership is usually reported in the balance sheet as a
single amount for each owner rather than distinction between the owners
initial investment and the accumulated earnings retained in the business.
For e.g. In a sole-proprietors balance sheet for the year 2011, the capital
account of the owner may appear as follows:

Rs.
Owners capital as on 1-1-2011 2,50,00
Add: 2011 profit 30,000

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Less: 2011 drawings 2,80,00


15,000
Owners capital as on 31-12-2011 2,65,000

Joint Stock Companies:

In the case of joint stock companies, according to the legal


requirements, owners equity is divided into two main categories. The
first category called share capital or contributed capital is the amount
the owners have invested directly in the business. The second category of
owners equity is called retained earnings.

m
co
Share capital is the capital stock pre-determined by the company
by the time of registration. It may consist of ordinary share capital or
s.
preference share capital or both. The capital stock is divided into units
bu
called as shares and that is why the capital is called as share capital. The
entire predetermined share capital called as authorised capital need not be
la

raised at a time. That portion of authorised capital which has been issued
for subscription as on a date is referred to as issued capital.
yl
lls

Retained earnings is the difference between the total earning to


date and the amount of dividends paid out to the shareholders to date.
.a

That is, the difference represents that part of the total earnings that have
w

been retained for use in the business. It may be noted that the amount of
w

retained earnings on a given date is the accumulated amount that has been
retained in the business from the beginning of the companys existence up
w

to that date. The owners equity increases through retained earnings and
decreases when retained earnings are paid out in the form of dividends.

1.3.3.9 Summary

The profit and loss account or income statement summarizes the


revenues and expenses of a business enterprise for an accounting period.
The information on the income statement is regarded by many to be more
important than information on the balance sheet because the income
statement reports the results of operations and enables to analyze the
reasons for the enterprises profitability or loss thereof. A close relationship

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exists between income statement and balance sheet; the statement of


retained earnings which is a concomitant of income statement explains
the change in retained earnings between the balance sheets prepared at the
beginning and the end of the period.

Balance sheet is one of the most important financial statements


which shows the financial position of a business enterprise as on a
particular date. It lists as on a particular date, usually at the close of the
accounting period, the assets, liabilities and capital of the enterprise.
An analysis of balance sheet together with profit and loss account will
give vital information about the financial position and operations of the
enterprise. The analysis becomes all the more useful and effective when a
series of balance sheets and profit and loss accounts are studied.

m
co
1.3.3.10 Key Words
s.
bu
Income: Revenues expenses.
Expense: Item of cost applicable to an accounting period.
la

Cost Of Goods Sold: Opening stock + purchase + freight closing stock.


Gross Profit: Excess of sales revenue over cost of goods sold.
yl
lls

Operating Expenses: Expenses incurred for running the business.


Operating Profit: Gross profit operating expenses.
.a
w

Non Operating Expenses: Expenses which are not related to the activities
w

of the business.
Net Profit: Amount of profit finally available to the enterprise for
w

appropriation.

Retained Earnings:
The term retained earnings means the accumulated excess of
earnings over losses and dividends.
Status Report: Financial position on a particular date.

Flow Report:
Financial position for a particular period.
Assets: costs which represent expected future economic benefits to the
business enterprise.

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Liabilities:
Represent obligations which require settlement in the future.

Current Assets:
Assets which are reasonably expected to be realized in cash or sold
or consumed during the normal operating cycle of the business enterprise
or within one year, whichever is longer.

Operating Cycle:
The average period of time between the purchase of goods or raw
materials and the realization of cash from the sale of goods.
Fixed Assets: tangible assets used in the business that are of a permanent
or relatively fixed nature.

m
co
Intangible Assets:
Those assets which have no physical existence.
s.
bu
Fictitious Assets:
They are not assets but appear in the asset side simply because of a
la

debit balance in a particular account not yet written off.


yl

Current Liabilities:
lls

Liabilities due within an accounting period or the operating cycle


of the business.
.a
w

Long Term Liabilities:


w

Liabilities that become due for payment after one year.


w

Contingent Liabilities:
Items which become a liability only on the happening of a certain
event.
Capital Or Owners Equity:
Tthis is the residual interest in the assets of the Enterprise.

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1.3.3.11 Self Assessment Questions

1. What is an expenditure? When does it become an expense?


2. What is income? How is it different from receipt?
3. Explain the following:
(a) gross profit
(b) operating profit
(c) earnings before interest and tax
(d) earnings after tax
4. What is meant by statement of retained earnings?
5. The following are the balances taken from the books of meena
ltd. On 31st december 2011:

m
Stock on 1-1-2011 15,000 Salaries 800

co
Debtors 5,000 Bank account 3,400
Wages 8,000 Rent 2,000
Creditors 6,000 Bad debts reserve 175 s.
bu
Sales 40,000 Discount allowed 250
P&l a/c 3,500 Bad debts 150
la

Returns inward 500 General expenses 1,300


Purchases 6,000 Insurance 300
yl

Plant 18,000 Dividend (interim) 575


lls

Discounts earned 200 Capital 12,000


Cash in hand 600
.a
w

Closing stock was valued at rs.9,000. Rs.500 still due to labourers.


w

Insurance unexpired rs.50. Provide for a bad debts reserve of 5% and a


reserve for discount at 1%. Prepare trading and profit and loss account as
w

at 31st december 2011.

6. From the following figures relating to a leading software producing


company, prepare the income statement for the year ended 30th june 2012.

1. Sales 20,17,69,212
2. Dividend received 1,06,755
3. Costs of goods sold 5,86,88,675
4. Interest received 18,76,661
5. Manufacturing expenses 5,38,56,719
6. Selling expenses 81,81,822

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7. Administration expenses 2,99,32,794


8. Managerial remuneration 1,78,200
9. Excise duty 48,94,360
10. Bad debts 16,48,157
11. Overseas project expenses 58,35,260
12. Interest paid 5,69,16,495
13. Depreciation 2,33,40,163
14. Auditors remuneration 71,488
15. Increase in stocks 9,16,30,652
16. Other income 94,13,004
17. Balance of profit brought forward from previous year 3,51,87,048
18. Proposed dividend 4,64,19,410
19. Transfer to general reserve 30,62,608

m
co
Also Prepare the Statement of Retained Earnings.

7. Explain the following: s.


bu
(a) assets
(b) liabilities
la

(c) fictitious assets


(d) income received in advance
yl

(e) investments
lls

8. What are the two forms of presenting a balance sheet?


9. Explain owners equity. How is it to be presented in the balance sheet?
.a

10. From the following trail balance extracted from the books of the
w

general traders limited as on 31st december 2005, you are required to


w

prepare trading and profit and loss account and balance sheet:
w

Rs Rs

Share capital 20,000 shares of rs.10 each 2,00,000


Stock on 1st january 2005 36,000
Sales 58,000
Salaries 5,250
Purchases 44,000
Sundry debtors 23,000
Wages 3,000
Calls in arrears 21,500
Sundry creditors 7,200

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Postage and telegrams 470


Advertisement 960
Preliminary expenses 7,500
Printing and stationery 640
Land and buildings 65,000
General expenses 2,200
Furniture 1,200
Repairs 650
Bad debts 910
Rent received 2,700
Machinery 30,000
Cash with bank 24,100
Cash in hand 1,520

m
2,67,900 2,67,900

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The stock on 31st december 2011 was rs.49,000. Write off rs.2,500 out of
s.
preliminary expenses. Depreciate machinery by 10 percent and furniture
bu
by 6 percent.
la

11. The books of aranarasu show the following balances as on 31st


december 2011. You are required to prepare a trading and profit and loss
yl

account and balance sheet.


lls

Rs. Rs.
.a
w

Stock on 1st january 2011 67,000


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Sales 5,24,600
Bills payable 1,500
w

Purchases 4,88,000
Salaries and wages 9,800
Rent 1,100
Travelling expenses 2,600
Sundry creditors 57,000
Postage and telegrams 620
General charges 2,250
Printing and stationery 350
Capital account 75,000
Interest and commission 2,200
Lighting charges 175

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Repairs 35
Sundry receipts 175
Furniture 3,000
Bills receivable 4,000
Bad debts 475
Sundry debtors 85,000
Aranarasus current account 17,000
Cash with bank 6,500
Cash in hand 2,170

6,75,275 6,75,275

Depreciate furniture by 6 percent. Outstanding salaries and rent were

m
rs.1,100 and rs.100 respectively. Stock at 31st december 2011 was valued

co
at rs.70,350.

s.
12. From the following balances relating to software india ltd. Prepare the
bu
Balance sheet as at 31st december 2011.
la

Rs.
yl

(a) equity capital 36,42,58,510


lls

(b) reserves and surplus 23,58,26,861


(c ) debentures 1,03,36,000
.a

(d) secured loans 21,27,57,441


w

(e) fixed assets 37,07,93,048


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(f) investments 5,94,80,459


(g) inventories 20,78,28,095
w

(h) sundry debtors 10,21,66,468


(i) cash and bank balances 1,49,87,264
(j) other current assets 57,75,568
(k) loans and advances 12,49,59,370
(l) current liabilities 4,71,71,358
(m) provisions 4,64,19,410
(n) miscellaneous expenditure 3,07,79,308

The balance sheet may be prepared in account form and report form.

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1.3.3.12 Key To Self Assessment Questions (For Problems Only)

Q.no.5: gross profit: rs.19,000; net profit: rs.14,327; profit carried to


Balance sheet: rs.17,252.
Q.no.6: net profit: rs.6,12,52,151; retained earnings balance:
Rs.4,69,57,182.
Q.no.10: gross profit: rs.24,000; net profit: rs.10,048; balance sheet
Total: rs.1,95,748.
Q.no.11: gross profit: rs.39,950; net profit: rs.19,140; balance sheet
Total: rs.1,70,840.

1.3.3.13 Case Analysis

m
To give a practical insight to the students about the various aspects

co
of profit and loss account and of a balance sheet we give the financial
statements as on 31st march 2012 of tt limited a yarn manufacturing
company: s.
bu
la
yl
lls
.a
w
w
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Tt Limited

Balance Sheet As At 31st March, 2005

I. Sources Of

Funds 1 107490250.00 107490250.00

1. Share Capital 2 202213218.39 190240718.95

Reserve & Surplus

2. Loan Funds 3 447855991.83 423528431.00

Secured Loans 4 69532615.80 56901290.19

m
Unsecured Loans

3. Deferred Tax 42276806.36 43673781.36

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Liability 869368882.38 821834471.50

s.
bu
Ii. Application
la

of Funds
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1. Fixed Assets
lls

Gross Block 5 734104404.86 700390441.72


.a

Less: Depreciation 217233181.41 184869109.73


Net Block
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516871223.45 515521331.99
Capt. Work In 521176823.45 515521331.99
w

4305600.00 0.00
Progress/ Advances
w

2. Investments 6 1591141.57 1591642.57

3. I.Current Assets, 510807958.00 457861043.73


Loans & Advances

Ii. Less: Current

Liabilities & 164207040.63 153139546.79


Provisions 7

Net Current 346600917.37 304721496.94

Assets (I-Ii) 869368882.38 821834471.50

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Tt Limited

Profit & Loss Account For The Year Ended 31st March, 2012

Particulars Schedule Current year Previous year


Rs. Rs.
INCOME
Sales 1656633139.30 1470167645.65
Less: Excise 9164920.45 59656449.44
Duty ------------------ ------------------
8 1649235545.85
Net Sales 9 3194055.78 1410511196.21
Other Income 10 23509662.45 9178442.33
Increase 22572632.64
(Decrease) ------------------ ------------------

m
In Stock 1675939264.08 1442262271.18

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11 ------------------ ------------------
Expenditure
Material
Manufactu- 1262208246.11 s. 1107760578.66
bu
ring, 12
Personnel, 13
Admin. & 308899137.99 254353516.32
la

Selling 47902372.00 30855197.88


yl

Expenses etc.
Financial
lls

expenses 34107486.97
Depre. on
.a

Fixed 33127938.23
Assets 2906557.05
w

Less: ------------
w

Transferred
from 31200929.92 3657679.05 29470259.18
w

Revaluation ----------------- ------------- -----------------


Reserve 1650210686.02 1422439552.04
------------------ -----------------

PROFIT
2000000.00
Profit Before
- 396975.00 25728578.06 19822719.14
Tax
-------------
Less:Provision
for Taxation
- for The Year
400000.00 5150084.00
- Deferred Tax
603025.00 4750084.00
Add: Taxation
------------- 2154911.83
Adjustment
0.00

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Of Previous
Years (Net)
Profit After 25125553.06 16827546.97
Taxation 33458012.39 28831460.48
Add: Balance --------------- ---------------
B/F From 58583565.45 45659007.45
Previous Year --------------- ---------------

8599220.00 8599220.00
1123810.56 1101775.06

10000000.00 2500000.00

38860534.88 33458012.19

m
--------------- ---------------
58583565.45 45659007.45

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--------------- ---------------

s.
bu
la

Appropriation
Dividend
yl

1.57
Dividend
lls

Distribution Tax
Trf. To General 2.34
.a

Reserve
Balance Carried
w

Forward
w
w

Earning Per
Share (Equity
Shares, Par
Value
Rs.10 Each)
Basic & Diluted

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1.3.3.14 Books For Further Reading

1. M.A.Arulanandam And K.S.Raman: Advanced Accounts,


Himalaya Publishing House.
2. R.L.Gupta And M.Radhaswamy: Advanced Accounts, Vol.I,
Sultan Chand & Sons, New Delhi.
3. S.P.Jain And K.L.Narang: Advanced Accounts, Kalyani Publishers.
4. M.C.Shukla And T.S.Grewal: Advanced Accounts, S.Chand & Co.
New Delhi.
5. Tulsian: Financial Accounting, Pearson Education.

*****

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co
s.
bu
la
yl
lls
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w
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s.
bu
la
yl
lls
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w
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Revenue Recognition
Lesson 1.4: Capital and Revenue Expenditure and Receipts

1.4.1 Introduction

In the previous lessons pertaining to the preparation of profit


and loss account, the reader would have had an exposure to the concepts
relating to expenses, expenditure and incomes. The term expenditure is a
broad term and it is classified into capital expenditure, revenue expenditure
and deferred revenue expenditure. All incomes are not receipts and all
receipts are not incomes. For example, under accrual or mercantile system

m
of accounting even income earned but not received is treated as income.

co
Similarly all receipts are not recognised as incomes. This lesson deals with
the classification of capital and revenue expenditure and receipts.
s.
bu
1.4.2 Learning Objectives
la

After reading this lesson the reader should be able to:


yl

Understand capital expenditure


lls

Distinguish capital expenditure from revenue expenditure


Identify capital receipts and revenue receipts
.a
w

1.4.3 Contents
w

1.4.3.1. Capital Expenditure


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1.4.3.2. Revenue Expenditure


1.4.3.3. Distinction Between Capital And Revenue Expenditure
1.4.3.4. Deferred Revenue Expenditure
1.4.3.5. Capital And Revenue Profits, Receipts And Losses
1.4.3.6. Illustrations
1.4.3.7. Summary
1.4.3.8. Key Words
1.4.3.9. Self Assessment Questions
1.4.3.10. Key To Self Assessment Questions
1.4.3.11. Case Analysis
1.4.3.12. Books For Further Reading

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1.4..3.1 Capital Expenditure:

Capital expenditure is that expenditure, the benefit of which is


not fully consumed in one period but spread over periods i.e. The benefits
are expected to accrue for a long time. Any expenditure which gives the
following outcomes is a capital expenditure:

(i) increases the capacity of an existing asset.


(ii) increases the life of an existing asset.
(iii) increases the earning capacity of the concern.
(iv) results in the acquisition of a new asset.
(v) decreases the cost of production.

m
Following are the examples of capital expenditure:

co
(i) expenditure resulting in the acquisition of fixed assets e.g. Land,
building, machines, etc.
s.
(ii) expenditure resulting in extension or improvement of fixed
bu
assets e.g. Amount spent on increasing the seating accommodation in the
picture hall.
la

(iii) expenditure in connection with installation of a fixed asset.


(iv) expenditure incurred for acquiring the right to carry on a
yl

business e.g. Patents, copyright, etc.


lls

(v) major repairs and replacements of parts resulting in increased


efficiency of a fixed asset.
.a

An expenditure cannot be said to be a capital expenditure only because:


w

(i) the amount is large.


w

(ii) the amount is paid in lump sum.


(iii) the amount is paid out of that fund which has been received
w

out of the sale of fixed asset.


(iv) the receiver of the amount is going to treat it for the purchase
of fixed asset.

1.4.3.2 Revenue Expenditure:

An expenditure which is consumed during the current period


and which affects the income of the current period is called revenue
expenditure. Also an expenditure which merely seeks to maintain the
business of high assets in good working conditions is revenue expenditure.

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Following are the examples of revenue expenditure:


(i) Expenses of administration, expenses incurred in manufacturing
and selling products.

(ii) Replacements for maintaining the existing permanent assets.

(iii) Costs of goods purchased for resale.

(iv) Depreciation on fixed assets, interest on loans for business, etc.

1.4.3.3 Distinction Between Capital And Revenue Expenditure:

The proper distinction between capital and revenue as regard to

m
expenditure, payments, profits, receipts and losses is one of the fundamental

co
principles of correct accounting. It is very essential that in all cases this
distinction should be rigidly observed and amounts rightly allocated
s.
between capital and revenue. Failure or neglect to discriminate between
bu
the two will falsify the whole of the results of accounting. However, the
distinction is not always easy. In actual practice there is a good deal of
la

difference of opinion as to whether a particular item is capital or revenue


expenditure. However, the rules mentioned above may serve as a guide for
yl

making distinction between capital and revenue expenditure.


lls

1.4.3.4 Deferred Revenue Expenditure:


.a
w

A heavy expenditure of revenue nature incurred for getting benefit


w

over a number of years is classified as deferred revenue expenditure.


In some cases the benefit of revenue expenditure may be available for
w

a period of two or three or even more years. Such expenditure is to be


written off over a period of two or three years and not wholly in the year
in which it is incurred. For example a new firm may advertise very heavily
in the beginning to capture a position in the market. The benefit of this
advertisement campaign will last quite a few years. It will be better to write
off the expenditure in three or four years and not only in the first year.
Some other examples of deferred revenue expenditure are preliminary
expenses, brokerage on issue of shares and debentures, exceptional repairs,
discount on issue of shares or debentures, expenses incurred in removing
the business to more convenient premises and so on.

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1.4.3.5 Capital And Revenue Profits, Receipts And Losses:

Capital and revenue profits:

Capital profit is a profit made on the sale of a fixed asset or a profit


earned on getting capital for the business. For example, if the original
cost of a fixed asset is rs.50,00,000 and if it is sold for rs.60,00,000 then
rs.10,00,000 is capital profit. Similarly if the shares having an original cost
of rs.4,000 are sold for rs.5,000, the profit of rs.1,000 thus made is capital
profit. Capital profits should not be transferred to the profit and loss
account but should be transferred to capital reserve which would appear
as a liability in the balance sheet. Revenue profit, on the other hand, is a
profit by trading, e.g. Profit on sale of goods, income from investments,

m
discount received, commission earned, rent received, interest earned etc.

co
Such profits are taken to profit and loss account.

Capital And Revenue Receipts: s.


bu
The distinction between capital receipts and revenue receipts is also
la

important. Money obtained from the sale of fixed assets of investments,


issue of shares, debentures, money obtained by way of loans are examples
yl

of capital receipts. On the other hand, revenue receipts are cash from sales,
lls

commission received, interest on investments, transfer fees, etc. Capital


receipts are shown in the balance sheet and revenue receipts in the profit
.a

and loss account.


w
w

Capital And Revenue Losses:


w

Capital losses are those losses which occur at selling fixed assets
or raising share capital. For e.g., if investments having an original cost
of rs.20,000 are sold for rs.16,000, there will be a capital loss of rs.4,000.
Similarly when the shares of the face value of rs.100 are issued for rs.90,
the amount of discount i.e. Rs.10 per share will be a capital loss. Capital
losses should not be debited to profit and loss account but may be shown
on the asset side of balance sheet. As and when capital profits arise, losses
are met against them. Revenue losses are those losses which arise during
the normal course of business i.e. In trading operations such as losses on
the sale of goods. Such losses are debited to profit and loss account.

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1.4.3.6 Illustrations

Illustration 1:
State which of the following expenditures are capital in nature and
which are revenue in nature:
Freight and cartage on the new machine rs.150; erection
charges Rs.200.
A sum of rs.10,000 on painting the new factory.
Fixtures of the book value of rs.1,500 was sold off at rs.600 and
new fixtures of the value of rs.1,000 were acquired, cartage on
purchase rs.50.
Rs.1,000 spent on repairs before using a second hand car purchased
recently.

m
co
Solution:

s.
Capital expenditure to be debited to machinery account.
bu
Painting charges of new or old factory are maintenance charges
and be charged to revenue. However, if felt proper, painting charges
la

of new factory may be treated as deferred revenue expenditure.


However, some say painting of new factory is capital expenditure.
yl

Loss of rs.900 on the sale of fixtures be treated as revenue expense


lls

but the cost of new fixture rs.1,000 together with cartage rs.50 be
debited to fixture account as these are capital expenditure.
.a

Rs.1,000 being expense to bring the asset in usable condition is a


w

capital expenditure.
w

Illustration 2:
w

The sum of rs.30,000 has been spent on a machine as follows:


Rs.20,000 for additions to increase the output; rs.12,000 for
repairs necessitated by negligence and rs.8,000 for replacement of
worn-out parts.
The sum of rs.17,200 was spent on dismantling, removing and
reinstalling in order to remove their works to more suitable
premises. Classify these expenses into capital and revenue.

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Solution:

R s.20,000 spent on additions is to be capitalized but rs.12,000


and rs.8,000 spent on repairs and replacement of worn-out parts
respectively are to be charged to revenue.
Rs.17,200 spent for removing to a more suitable premises is to be
charged to revenue as it does not increase efficiency and income.
It, may, however be treated as deferred revenue at the most.

1.4.3.7 Summary

Final accounts are prepared from the balances appearing in the


trial balance. All accounts appearing in the trial balance are taken to

m
either trading and profit and loss account or balance sheet. All revenue

co
expenditures and receipts are taken to trading and profit and loss account
and all capital expenditures and receipts are taken to balance sheet. It is
s.
therefore necessary to realise the importance of distinction between capital
bu
and revenue items.
la

1.4.3.8 Key Words


yl

Capital Expenditure:
lls

It is that expenditure, the benefit of which is expected to accrue for


.a

a number of years.
w
w

Revenue Expenditure:
w

It is that expenditure, the benefit of which is consumed during the


current year.

Capital Receipt:

Moneys obtained from sale of fixed assets, issue of capital,


borrowing of loans, etc.
Revenue Receipt: cash from sales, commission received, etc. Are examples
of revenue receipts.

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1.4.3.9 Self Assessment Questions

State which of the following items should be charged to capital and


which to revenue:
(i) Rs.6,000 paid for removal of stock to new site.
(ii) Rs.2,000 paid for the erection of a new machine.
(iii)Rs.2,500 paid on the repairing of new factory.
(iv) A car engines rings and pistons were changed at a cost of
rs.15,000; this resulted in improvement of petrol consumption to 12 km
per litre; earlier it had fallen from 15 km to 8 km.

1.4.3.10 Key To Self Assessment Questions


(i) Deferred revenue expenditure.

m
(ii) Capital expenditure.

co
(iii) Capital expenditure.
(iv) Revenue expenditure.
s.
bu
1.4.3.11 Case Analysis
la

Raja ram ltd., for which you are the accounts manager, has removed
the works factory to a more suitable site. During the removal process the
yl

following stream of expenditure were incurred:


lls

a)A sum of rs.47,500 was spent on dismantling, removing and


reinstalling plant, machinery and fixtures.
.a

b)The removal of stock from old works to new works cost rs.5,000.
w

c)Plant and machinery which stood in books at rs.7,50,000 included


w

a machine at a book value of rs.15,000. This being obsolete was sold off for
rs.5,000 and was replaced by a new machine which costs rs.24,000.
w

d)The fixtures and furniture appeared in the books at rs.75,000. Of


these, some portion of the book value of rs.15,000 was discarded and sold
off for rs.16,000 and new furniture of the value of rs.12,000 was acquired.
e)A sum of rs.11,000 was spent on painting the new factory.

Your accounts clerk has come to you seeking your help to classify the above
expenditure as to capital expenditure and revenue expenditure. Advise
him.

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Solution:

a)Rs.47,500 will have to be treated as revenue expenditure. It may


be treated as deferred revenue expenditure item and spread over a term of
say four to five years.
b)The cost of removal of stock from the old works to the new works
does not either add to the value of the profit earning capacity of the asset
and as such it should be treated as an item of revenue expenditure.
c)Rs.10,000, the difference between the book value of the machine
sold and the amount realized on sale, will have to be charged off to
revenue as depreciation. Rs.24,000, the cost of new machine, will have to
be capitalized.
d)Rs.1,000, the difference between the book value of the fixtures

m
and fittings discarded and the amount realized from there will be treated

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as capital profit and therefore be credited to capital revenue account.
Rs.12,000, the cost of new furniture, will be capitalized.
s.
e)A sum of rs.11,000 spent on painting a new factory is capital
bu
expenditure and will be added to the cost of factory building as it is all to
the new factory.
la

1.4.3.12 Books For Further Reading


yl
lls

a) R.L.Gupta And M.Radhaswamy: Advanced Accounts,


Sultan Chand & Sons, New Delhi.
.a

b) S.P.Jain And K.L.Narang: Advanced Accountancy, Kalyani


w

Publishers, New Delhi.


w

c) M.C.Shukla And T.S.Grewal: Advanced Accounts, S.Chand


& Co., New Delhi.
w

d) Tulsian: Financial Accounting,, Pearson Education (P) Ltd.,


Delhi.
e) Warren Reeve Fess: Financial Accounting, Thomson, South
Westem.

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Unit-II

Lesson 2.1: Depreciation

2.1.1 Introduction

With the passage of time, all fixed assets lose their capacity to
render services, the exceptions being land and antics. Accordingly, a
fraction of the cost of the asset is chargeable as an expense in each of the
accounting periods in which the asset renders services. The accounting

m
process for this gradual conversion of capitalised cost of fixed assets into

co
expense is called depreciation. This lesson explains the different aspects of
depreciation.
s.
bu
2.1.2 Learning Objectives
la

After reading this lesson, the reader should be able to:


yl

Understand the meaning of depreciation.


lls

Know the causes of depreciation.


Appreciate the need for depreciation accounting.
.a

Evaluate the methods of depreciation.


w

2.1.3 Contents
w
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2.1.3.1 Meaning Of Depreciation


2.1.3.2 Causes Of Depreciation
2.1.3.3 Need For Depreciation Accounting
2.1.3.4 Methods Of Depreciation
2.1.3.5 Straight Line Method Of Depreciations
2.1.3.6 Diminishing Balance Method
2.1.3.7 Annuity Method Of Depreciation
2.1.3.8 Summary
2.1.3.9 Key Words
2.1.3.10 Self Assessment Questions
2.1.3.11 Key To Self Assessment Questions

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2.1.3.12 Case Analysis


2.1.3.13 Books For Further Reading

2.1.3.1 Meaning Of Depreciation

In common parlance depreciation means a fall in the quality or value


of an asset. But in accounting terminology, the concept of depreciation
refers to the process of allocating the initial or restated input valuation
of fixed assets to the several periods expected to benefit from their
acquisitions and use. Depreciation accounting is a system of accounting
which aims to distribute the cost or other basic value of tangible capital
assets, less salvage (if any), over the estimated useful life of the unit (which
may be a group of assets) in a systematic and rational manner. It is a process

m
of allocation and not of valuation.

co
The international accounting standards committee (iasc) (now
s.
international accounting standards board) defines depreciation as follows:
bu
depreciation is the allocation of the depreciable amount of an asset over
the estimated useful life. The useful life is in turn defined as the period
la

over which a depreciable asset is expected to be used by the enterprise.


The depreciable amount of a depreciable asset is its historical cost in the
yl

financial statements, less the estimated residual value. Residual value or


lls

salvage value is the expected recovery or sales value of the asset at the end
of its useful life.
.a
w

2.1.3.2 Causes Of Depreciation


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Among other factors, the two main factors that contribute to the
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decline in the usefulness of fixed assets are deterioration and obsolescence.


Deterioration is the physical process wearing out whereas obsolescence
refers to loss of usefulness due to the development of improved equipment
or processes, changes in style or other causes not related to the physical
conditions of the asset. The other causes of depreciation are:

1. Efflux of time mere passage of time will cause a fall in the


value of an asset even if it is not used.
2. Accidents an asset may reduce in value because of meeting
with an accident.
3. Fall in market price a sudden fall in the market price of

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the asset reduces its value even if it remains brand new.

2.1.3.3 Need For Depreciation Accounting

The need for depreciation accounting arises on three grounds:


(i) To calculate proper profit: according to matching concept
of accounting, profit of any year can be calculated only when all costs of
earning revenues have been properly charged against them. Asset is an
important tool in earning revenues. The fall in the book value of assets
reflects the cost of earning revenues from the use of assets in the current
year and hence like other costs like wages, salary, etc., it must also be
provided for proper matching of revenues with expenses.

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(ii) To show true financial position: the second ground for

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providing depreciation is that it should result in carrying forward only
that part of asset which represents the unexpired cost of expected future
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service. If the depreciation is not provided then the asset will appear in the
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balance sheet at the overstated value.
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(iii) To make provision for replacement of assets: if no changes


were made for depreciation, profits of the concern would be more to that
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extent. By making an annual charge for depreciation, a concern would


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be accumulating resources enough to enable it to replace an asset when


necessary. Replacement, thus, does not disturb the financial position of
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the concern.
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2.1.3.4 Methods Of Depreciation


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The amount of depreciation of a fixed asset is determined taking


into account the following three factors: its original cost, its recoverable
cost at the time it is retired from service and the length of its life. Out of
these three factors the only factor which is accurately known is the original
cost of the asset. The other two factors cannot be accurately determined
until the asset is retired. They must be estimated at the time the asset is
placed in service. The excess of cost over the estimated residual value
is the amount that is to be recorded as depreciation expense during the
assets life-time. There are no hard and fast rules for estimating either the
period of usefulness of an asset or its residual value at the end of such
period. Hence these two factors, which are inter-related are affected to a

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considerable extent by management policies.

Let the reader consider the following example: a machine is


purchased for rs.1,00,000 with an estimated life of five years and estimated
residual value of rs.10,000. The objective of depreciation accounting is
to charge this net cost of rs.90,000 (original cost residual value) as an
expense over the 5 year period. How much should be charged as an expense
each year? To give an answer to this question a 100 number of methods of
depreciation are available. In this lesson three such methods viz.

1.Straight line method,


2.Diminishing balance method and
3.Annuity method are discussed.

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2.1.3.5 Straight Line Method Of Depreciation

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This method which is also known as fixed installment system,
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provides for equal amount of depreciation every year. Under this method,
the cost of acquisition plus the installation charges, minus the scrap value,
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is spread over the estimated life of the asset to arrive at the annual charge.
In other words, this method writes off a fixed percentage, say 20%, of the
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original cost of the asset every year in such a way that the asset is reduced
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to nil or scrap value at the end of its life.


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Evaluation:
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The chief merit of this method is that it is easy to calculate


depreciation, and hence, it is simple. Depreciation charge is constant from
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year to year, regardless of the extent of use of the asset. This method can be
employed in the case of assets like furniture and fixtures, short leases, etc.,
which involve little capital outlay, or which have no residual value. This
method is criticized on the ground that the depreciation charge remaining
the same every year, cost of repairs and maintenance would be increasing
as the asset becomes older. With the efficiency of the asset declining, it is
unfair to charge the same amount of depreciation every year.

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2.1.3.6 Diminishing Balance Method

This method which is also known as the, `reducing installment


system, or `written down value method, applies depreciation as a fixed
percentage to the balance of the net cost of the asset not yet allocated at
the end of the previous accounting period. The percentage of depreciation
is so fixed that, theoretically, the balance of the unallocated cost at the end
of the estimated useful life of the asset should be equal to the estimated
residual value.

Evaluation:

Unlike the fixed installment system, depreciation under this

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method is not fixed, but gradually decreasing. As such, in the initial

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periods, the amount will be much higher, but negligible in the later period
of the asset. Thus, this method tends to offset the amount of depreciation
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on the one hand and repairs and maintenance on the other. This method is
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also simple, although the calculation of depreciation is a bit complicated.
Further, as and when additions are made to the asset, fresh calculations do
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not become necessary. This method is best suited to assets such as plant
and machinery which have a long life.
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Entries Required:
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The entry to be made on writing off depreciation under any method


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is:
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Depreciation a/c .. Dr
To asset a/c
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The depreciation account goes to the debit of the profit and loss account.
The entry for this is:
Profit and loss a/c dr
To depreciation a/c

The asset appears at its reduced value in the balance sheet.

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Illustration 1:

On 1-1-2003, machinery was purchased for rs.3,00,000. Depreciation


at the rate of 10% has to be written off. Write up the machinery account for
three years under:
1. Straight line method (SLM) and
2. Written down value method (WDV)

Solution:

Machinery Account
Date Particulars SLM WDV Date Particulars SLM WDV
1-1- To Bank 3,00,000 3,00,000 31-12- By 30,000 30,000

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2003 A/C 2003 Depreciation 2,70,000 2,70,000
---------- ---------- 31-12- By Balance --------- ----------

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3,00,000 3,00,000 2003 C/D 3,00,000 3,00,000
---------- ---------- --------- ----------

1-1- To Balance 2,70,000


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2,70,000 30,000 27,000
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2004 B/D 31-12- By 2,40,000 2,43,000
---------- ---------- 2004 Depreciation --------- ----------
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2,70,000 2,70,000 31-12- By Balance 2,70,000 2,70,000


---------- ---------- 2004 C/D --------- ----------
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1-1- To Balance 2,40,000 2,43,000 30,000 24,300


2005 B/D 2,10,000 2,18,700
---------- ---------- 31-12- By --------- ----------
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2,40,000 2,43,000 2005 Depreciation 2,40,000 2,43,000


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---------- ---------- 31-12- By Balance --------- ----------


2005 C/D
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1-1- To Balance 2,10,000 2,18,700


2006 B/D
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From the above illustration it can be seen that under SLM method
each year depreciation is calculated at 10% on original cost of asset i.e. On
rs.3,00,000, while under WDV method each year depreciation is calculated
at 10% on the written down value i.e. For e.g. In the 2nd year depreciation
is calculated at 10% on rs.2,70,000 and so on.

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Illustration 2:

On 1-1-2002, machinery was purchased for rs.30,000. Depreciation


at the rate of 10% on original cost was written off during the first two years.
For the next two years 15% was written off the diminishing balance of the
amount. The machinery was sold for rs.15,000. Write up the machinery
account for four years and close the same.

Machinery Account
Date Particulars SLM Date Particulars SLM
1-1-2002 To Bank 30,000 31-12- By 3,000
A/C 2002 Depreciation 27,000
---------- 31-12- By Balance ----------

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30,000 2002 C/D 30,000
---------- ----------

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1-1-2003 To Balance 27,000 3,000
B/D
----------
31-12-
2003 s.
By 24,000
Depreciation ----------
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27,000 31-12- By Balance 27,000
---------- 2003 C/D ----------
1-1-2004
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To Balance 24,000 3,600


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B/D
31-12- By 2,0,400
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---------- 2004 Depreciation ----------


2,40,000 31-12- (15% On 24,000
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---------- 2004 24,000) ----------


20,400 By Balance 3,060
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1-1-2005 To Balance C/D


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B/D 15,000
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------- 31.122005 2,340


20,400 By ---------
31.12.2005 Depreciation 20,400
31.12.2005 (15% On
20,400)
By Bank
(Sale)
By Profit &
Loss A/C
(Loss On
Sale)

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Illustration 3:

A company, whose accounting year is the calendar year, purchased


a machinery on 1-1-2003 for rs.40,000. It purchased further machinery on
1-10-2003 for rs.20,000 and on 1st july 2005 for rs.10,000. On 1-7-2006,
one-fourth of the machinery installed on 1-1-2003 became obsolete and
was sold for rs.6,800. Show the machinery account for all the 3 years under
fixed installment system. Depreciation is to be provided at 10%p.a.

Machinery Account
Date Particulars Rupees Date Particulars Rupees
2003 2003
Jan 1 To Bank- 40,000 Dec 31 By Depreciation

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Oct 10 Purchase 20,000 -On Rs.40000 For 1 4,000
To Bank- Year 500

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Purchase Dec 31 -On Rs.20000 For 3 55,500
-------- Month --------
60,000
-------- s.
By Balance C/D
60,000
--------
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2004 2004
Jan 1 To Balance 55,500 Dec 31
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B/D 4,000
July 1 To Bank- 2,000
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Purchase 10,000 By Depreciation 500


Dec 31 -On Rs.40000 For 1 59,000
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-------- Year --------


65,500 -On Rs.20000 For 1 65,500
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-------- Year --------


-On Rs.10000 For 6
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Month
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2005 By Balance C/D


59,000 July 1 500
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July 1 6,800
July 1 700
2005 To Balance
Jan 1 B/D Dec 31
By Depreciation 3,000
On Machine Sold 2,000
By Bank-Sale 1,000
By P&L A/C (Loss On 45,000
-------- Sale) --------
59,000 By Depreciation 59,000

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-On Rs.30000 For 1 Year


-On Rs.20000 For 1 Year
-On Rs.10000 For 1 Year
By Balance C/D

Working Notes Loss On Sale Of Machinery

Original cost of machinery on 1-1-2003: = 10,000


Less depreciation for 2003 at 10% 1,000 (4000 x ) = 1,000
--------
Book value on 1-1-2004 9,000
Less depreciation for 2004 at 10% on 10,000 1,000

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--------
Book value on 1-1-2005 8,000

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Less depreciation upto 1-7-2005 at 10% on 10000 500
--------
Book value on date of sale s.
7,500
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Less sale proceeds 6,800
--------
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Loss on sale 700


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--------
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2.1.3.7 Annuity Method Of Depreciation


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Under the first two methods of depreciation the interest aspect has
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been ignored. Under this method, the amount spent on the acquisition of
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an asset is regarded as investment which is assumed to earn interest at a


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certain rate. Every year the asset is debited with the amount of interest and
credited with the amount of depreciation. This interest is calculated on the
debit balance of the asset account at the beginning of the year. The amount
to be written off as depreciation is calculated from the annuity table an
extract of which is given below:
Years 3% 3.5% 4% 4.5% 5%
3 0.353530 0.359634 0.360349 0.363773 0.367209
4 0.269027 0.272251 0.275490 0.278744 0.282012
5 0.218355 0.221481 0.224627 0.227792 0.230975

The amount to be written off as depreciation is ascertained from

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the annuity table and the same depends upon the rate of interest and the
period over which the asset is to be written off. The rate of interest and the
amount of depreciation would be adjusted in such a way that at the end of
its working life, the value of the asset would be reduced to nil or its scrap
value.

Evaluation:

This method has the merit of treating purchase of an asset as an


investment within the business, and the same is supposed to earn interest.
However, calculations become difficult when additions are made to the
asset. The method is suitable only for long leases and other assets to which
additions are not usually made and as such in case of machinery, this

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method is not found suitable.

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Illustration 4:
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A lease is purchased for a term of 4 years by payment of rs.1,00,000.
It is proposed to depreciate the lease by annuity method charging 4%
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interest. If annuity of re.1 for 4 years at 4% is 0.275490, show the lease


account for the full period.
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Amount of annual depreciation =rs.1,00,000 x re.0.275490


= rs.27,549
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Lease Account
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Date Particulars Rupees Date Particulars Rupees


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1 s t To Bank 100000.00 1st By Depreciation 27549.00


Year To Interest At 4% 4000.00 Year By Balance C/D 76451.00
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------------ ------------
104000.00 104000.00
------------ ------------
2nd To Balance B/D 76451.00 2nd By Depreciation 27549.00
Year To Interest At 4% 3058.04 Year By Balance C/D 51960.04
------------ ------------
79509.04 79509.04
------------ ------------
3 r d To Balance B/D 51960.04 3rd By Depreciation 27549.00
Year To Interest At 4% 2078.40 Year By Balance C/D 26489.44
------------ ------------
54038.44 54038.44
------------ ------------

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4th To Balance B/D 26489.44 4th By Depreciation 27549.00


Year To Interest At 4% 1059.56 Year
(Adjusted) ----------- -----------
27549.00 27549.00
----------- -----------

2.1.3.8 Summary

Though depreciation to a common man means a fall in the value


of an asset, actually it is not a process of valuation. It is a process of cost
allocation. Through depreciation accounting the cost of a tangible asset
less salvage value, if any, is distributed over the estimated useful life of

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the asset. Depreciation is to be accounted to know the true profit earned
by the concern, to exhibit a true and fair view of the state of assets of

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the concern and to provide funds for replacement of the asset when it is
worn out. Among the number of methods of depreciation available three
s.
methods, viz. Straight line method, diminishing balance method and
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annuity method are discussed.
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2.1.3.9 Key Words


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Depreciable Asset: It is that asset on which depreciation is written off.


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Depreciation: It is the allocation of the depreciable amount of an asset


over estimated useful life.
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Useful Life: It is the period over which a depreciable asset is expected to


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be used by the enterprise.

Depreciable Amount: The depreciable amount of a depreciable asset is


its historical cost less estimated residual value.

Residual Value: It is the expected recovery or sales value of an asset at the


end of its useful life.

2.1.3.10 Self Assessment Questions

Question 1:
A manufacturing concern, whose books are closed on 31st

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march, purchased machinery for rs.1,50,000 on 1st april 2002. Additional


machinery was acquired for rs.40,000 on 30th september 2003 and for
rs.25,000 on 1st april 2005. Certain machinery which was purchased for
rs.40,000 on 30th september 2003 was sold for rs.34,000 on 30th september
2005. Give the machinery account for the year ending 31st march 2006
taking into account depreciation at 10% p.a. On the written down value.

Question 2:
A seven years lease has been purchased for a sum of rs.60,000
and it is proposed to depreciate it under the annuity method charging 4%
interest. Reference to the annuity table indicates that the required result
will be brought about by charging annually rs.9996.55 to depreciation
account. Show how the lease account will appear in each of the seven years.

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Question 3:

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Examine the need for providing depreciation.

s.
2.1.3.11 Key To Self Assessment Questions
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Question 1: Machinery Account
2005 2005
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April 1 to balance b/d 1,43,550 Sep 30 by depreciation 1,710


Sep 30 to bank 25,000 by bank 34,000
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to p&l a/c 1,510 2006 by depreciation 13,435


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(profit on sale) mar 31 by balance c/d 1,20,915



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1,70,060 1,70,060
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Question 2:
Interest for seven years:
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1st year: rs.2,400; 2nd year: rs.2,096.14; 3rd year: rs.1,780.12; 4th year:
Rs.1,451.46; 5th year: rs.1,109.66; 6th year: rs.754.19; 7th year: rs.384.28.

2.1.3.12 Case Analysis

Pondicherry roadways ltd. Which depreciates its machinery at


10% p.a. On written down value desires to change the basis to straight
line method, the rate remaining the same. The decision is taken on 31st
december 2005 to be effective from 1st january 2003.
On 1st january 2005, the balance in the machinery account is rs.29,16,000.
On 1st july 2005, a part of machinery purchased on 1st january 2003 for

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rs.2,40,000 was sold for rs.1,35,000. On the same day a new machine is
purchased for rs.4,50,000 and installed at a cost of rs.24,000.
Analyze the above case and answer the following questions:
(i) What was the loss incurred on the machine sold?
(ii) What was the book value of unsold machinery on 1-1-2003.
(iii) What would be the additional depreciation due to change in
method?
(iv) What should be the depreciation to be charged for 2005?
Answers:
(i) Rs.49,680
(ii) Rs.33,60,000
(iii)Rs.33,600
(iv)Rs.3,59,700

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2.1.3.13 Books For Further Reading

s.
1. R.L.Gupta And M.Radhaswamy: ADVANCED ACCOUNTS, Sultan
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Chand & Sons, New Delhi.
2. S.P.Jain And K.L.Narang: ADVANCED ACCOUNTANCY, Kalyani
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Publishers, New Delhi.


3. M.C.Shukla And T.S.Grewal: Advanced Accounts, S.Chand & Co., New
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Delhi.
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4. Tulsian: Financial Accounting, Pearson Education (P) Ltd., Delhi.


5. Warren Reeve Fess: Financial Accounting, Thomson, South Westam.
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*****
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UNIT-II

Lesson 2.2: Ratio Analysis

2.2..1 Introduction

Financial statements by themselves do not give the required


information both for internal management and for outsiders. They
are passive statements showing the results of the business i.e. Profit or
loss and the financial position of the business. They will not disclose
any reasons for dismal performance of the business if it is so. What is
wrong with the business, where it went wrong, why it went wrong, etc.

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Are some of the questions for which no answers will be available in the

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financial statements. Similarly, no information will be available in the
financial statements about the financial strengths and weaknesses of
s.
the concern. Hence, to get meaningful information from the financial
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statements which would facilitate vital decisions to be taken, financial
statements must be analysed and interpreted. Through the analysis and
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interpretation of financial statements full diagnosis of the profitability and


financial soundness of the business is made possible. The term `analysis of
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financial statements means methodical classification of the data given in


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the financial statements. The term `interpretation of financial statements


means explaining the meaning and significance of the data so classified. A
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number of tools are available for the purpose of analysing and interpreting
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the financial statements. This lesson discusses in brief tools like common
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size statement, trend analysis, etc., and gives a detailed discussion on ratio
analysis.
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2.2.2 Learning Objectives

After reading this lesson the reader should be able to:


understand the nature and types of financial analysis
know the various tools of financial analysis
understand the meaning of ratio analysis
ppreciate the significance of ratio analysis
understand the calculation of various kinds of ratios
calculate the different ratios from the given financial statements
interpret the calculated ratios

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2.2.3 Contents

2.2.3.1 Nature Of Financial Analysis


2.2.3.2 Types Of Financial Analysis
2.2.3.3 Tools Of Financial Analysis
2.2.3.4 Meaning And Nature Of Ratio Analysis
2.2.3.5 Classification Of Ratios
2.2.3.6 Capital Structure Or Leverage Ratios
2.2.3.7 Fixed Assets Analysis
2.2.3.8 Analysis Of Turnover (Or) Analysis Of Efficiency
2.2.3.9 Analysis Of Liquidity Position
2.2.3.10 Analysis Of Profitability
2.2.3.11 Analysis Of Operational Efficiency

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2.2.3.12 Ratios From Share Holders Point Of View

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2.2.3.13 Illustrations
2.2.3.14 Summary
2.2.3.15 Key Words s.
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2.2.3.16 Self Assessment Questions
2.2.3.17 Key To Self Assessment Questions
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2.2.3.18 Case Analysis


2.2.3.19 Books For Further Reading
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2.2.3.1 Nature Of Financial Analysis


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The focus of financial analysis is on the key figures contained


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in the financial statements and the significant relationship that exists


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between them. analyzing financial statements is a process of evaluating


the relationship between the component parts of the financial statements
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to obtain a better understanding of a firms position and performance.


The type of relationship to be investigated depends upon the objective and
purpose of evaluation. The purpose of evaluation of financial statements
differs among various groups: creditors, shareholders, potential investors,
management and so on. For example, short-term creditors are primarily
interested in judging the firms ability to pay its currently-maturing
obligations. The relevant information for them is the composition of
the short-term (current) liabilities. The debenture-holders or financial
institutions granting long-term loans would be concerned with examining
the capital structures, past and projected earnings and changes in the
financial position. The shareholders as well as potential investors would

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naturally be interested in the earnings per share and dividends per share
as these factors are likely to have a significant bearing on the market price
of shares. The management of the firms, in contrast, analyses the financial
statements for self-evaluation and decision making.

The first task of the financial analyst is to select the information


relevant to the decision under consideration from the total information
contained in the financial statements. The second step involved in
financial analysis is to arrange the information in such a way as to highlight
significant relationships. The final step is the interpretation and drawing
of inferences and conclusions. In brief, financial analysis is the process of
selection, relation and evaluation.

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2.1.3.2 Types Of Financial Analysis

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Financial analysis may be classified on the basis of parties who are
s.
undertaking the analysis and on the basis of methodology of analysis. On
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the basis of the parties who are doing the analysis, financial analysis is
classified into external analysis and internal analysis.
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External Analysis:
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When the parties external to the business like creditors, investors,


etc. Do the analysis, the analysis is known as external analysis. This analysis
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is done by them to know the credit-worthiness of the concern, its financial


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viability, its profitability, etc.


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Internal Analysis:
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This analysis is done by persons who have control over the books
of accounts and other information of the concern. Normally this analysis
is done by management people to enable them to get relevant information
to take vital business decision.
On the basis of methodology adopted for analysis, financial analysis may
be either horizontal analysis or vertical analysis.

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Horizontal Analysis:

When financial statements of a number of years are analysed, then


the analysis is known as horizontal analysis. In this type of analysis, figures
of the current year are compared with the standard or base year. This
type of analysis will give an insight into the concerns performance over a
period of years. This analysis is otherwise called as dynamic analysis as it
extends over a number of years.

Vertical Analysis:

This type of analysis establishes a quantitative relationship of the


various items in the financial statements on a particular date. For e.g. The

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ratios of various expenditure items in terms of sales for a particular year

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can be calculated. The other name for this analysis is `static analysis as it
relies upon one year figures only.
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2.1.3.3 Tools Of Financial Analysis
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The following are the important tools of financial analysis which


can be appropriately used by the financial analysts:
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1. Common-size financial statements


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2. Comparative financial statements


3. Trend percentages
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4. Ratio analysis
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5. Funds flow analysis


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6. Cash flow analysis


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Common-Size Financial Statements:

In this type of statements, figures in the original financial statements


are converted into percentages in relation to a common base. The common
base may be sales in the case of income statements (profit and loss account)
and total of assets or liabilities in the case of balance sheet. For e.g. In the
case of common-size income statement, sales of the traditional financial
statement are taken as 100 and every other item in the income statement is
converted into percentages with reference to sales. Similarly, in the case of
common-size balance sheet, the total of asset/liability side will be taken as
100 and each individual asset/liability is converted into relevant percentages.

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Comparative Financial Statements:

This type of financial statements are ideal for carrying out


horizontal analysis. Comparative financial statements are so designed to
give them perspective to the review and analysis of the various elements of
profitability and financial position displayed in such statements. In these
statements, figures for two or more periods are compared to find out the
changes both in absolute figures and in percentages that have taken place in
the latest year as compared to the previous year(s). Comparative financial
statements can be prepared both for income statement and balance sheet.

Trend Percentages:

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Analysis of one year figures or analysis of even two years figures will

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not reveal the real trend of profitability or financial stability or otherwise
of any concern. To get an idea about how consistent is the performance of
s.
a concern, figures of a number of years must be analysed and compared.
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Here comes the role of trend percentages and the analysis which is done
with the help of these percentages is called as trend analysis.
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Trend analysis:
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Is a useful tool for the management since it reduces the large


amount of absolute data into a simple and easily readable form. The trend
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analysis is studied by various methods. The most popular forms of trend


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analysis are year to year trend change percentage and index-number trend
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series. The year to year trend change percentage would be meaningful and
manageable where the trend for a few years, say a five year or six year
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period is to be analysed.

Generally trend percentage are calculated only for some important


items which can be logically related with each other. For e.g. Trend ratio for
sales, though shows a clear-cut increasing tendency, becomes meaningful
in the real sense when it is compared with cost of goods sold which might
have increased at a lower level.

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Ratio Analysis:

Of all the tools of financial analysis available with a financial analyst


the most important and the most widely used tool is ratio analysis. Simply
stated ratio analysis is an analysis of financial statements done with the
help of ratios. A ratio expresses the relationship that exists between two
numbers and in financial statement analysis a ratio shows the relationship
between two interrelated accounting figures. Both the accounting figures
may be taken from the balance sheet and the resulting ratio is called a
balance sheet ratio. But if both the figures are taken from profit and loss
account then the resulting ratio is called as profit and loss account ratio.
Composite ratio is that ratio which is calculated by taking one figure from
profit and loss account and the other figure from balance sheet. A detailed

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discussion on ratio analysis is made available in the pages to come.

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Funds Flow Analysis:
s.
bu
The purpose of this analysis is to go beyond and behind the
information contained in the financial statements. Income statement tells
la

the quantum of profit earned or loss suffered for a particular accounting


year. Balance sheet gives the assets and liabilities position as on a particular
yl

date. But in an accounting year a number of financial transactions take


lls

place which have a bearing on the performance of the concern but which
are not revealed by the financial statements. For e.g. A concern collects
.a

finance through various sources and uses them for various purposes. But
w

these details could not be known from the traditional financial statements.
w

Funds flow analysis gives an opening in this respect. All the more, funds
flow analysis reveals the changes in working capital position. If there is an
w

increase in working capital what resulted in the increase and if there is a


decrease in working capital what caused the decrease, etc. Will be made
available through funds flow analysis.

Cash Flow Analysis:

While funds flow analysis studies the reasons for the changes in
working capital by analysing the sources and application of funds, cash
flow analysis pays attention to the changes in cash position that has taken
place between two accounting periods. These reasons are not available
in the traditional financial statements. Changes in the cash position can

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be analysed with the help of a statement known as cash flow statement.


A cash flow statement summarises the change in cash position of the
concern. Transactions which increase the cash position of the concern are
labelled as `inflows of cash and those which decrease the cash position as
`outflows of cash.

2.2.3.4 Meaning And Nature of Ratio Analysis

Ratio expresses numerical relationship between two numbers.


In the words of kennedy and mcmullen, the relationship of one item to
another expressed in simple mathematical form is known as a ratio. Thus,
the ratio is a measuring device to judge the growth, development and
present condition of a concern. It plays an important role in measuring the

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comparative significance of the income and position statement. Accounting

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ratios are expressed in the form of time, proportion, percentage, or per
one rupee. Ratio analysis is not only a technique to point out relationship
s.
between two figures but also points out the devices to measure the
bu
fundamental strengths or weaknesses of a concern. As james c.van horne
observes: to evaluate the financial condition and performance of a firm,
la

the financial analyst needs certain yardsticks. One of the yardsticks


frequently used is a ratio. The main purpose of ratio analysis is to measure
yl

past performance and project future trends. It is also used for inter-firm
lls

and intra-firm comparison as a measure of comparative productivity. The


significance of the various components of financial statements can be
.a

judged only by ratio analysis. The financial analyst x-rays the financial
w

conditions of a concern by the use of various ratios and if the conditions


w

are not found to be favourable, suitable steps can be taken to overcome the
limitations. The main objectives of ratio analysis are:
w

T o simplify the comparative picture of financial statements.


To assist the management in decision making.
To guage the profitability, solvency and efficiency of an enterprise,
and
To ascertain the rate and direction of change and future potentiality.

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2.2.3.5 Classification of Ratios

Financial ratios may be categorised in various ways. Van horne has


divided financial ratios into four categories, viz., liquidity, debt, profitability
and coverage ratios. The first two types of ratios are computed from the
balance sheet. The last two are computed from the income statement and
sometimes, from both the statements. For the purpose of analysis, the
present lesson gives a detailed description of ratios, the formula used for
their computation and their significance. The ratios have been categorised
under the following headings:-
(i) ratios for analysis of capital structure or leverage.
(ii) ratios for fixed assets analysis.
(iii) ratios for analysis of turnover.

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(iv) ratios for analysis of liquidity position.

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(v) ratios for analysis of profitability.
(vi) ratios for analysis of operational efficiency.
s.
bu
2.2.3.6 Capital Structure or Leverage Ratios
la

Financial strength indicates the soundness of the financial resources


of an organisation to perform its operations in the long run. The parties
yl

associated with the organisation are interested in knowing the financial


lls

strength of the organisation. Financial strength is directly associated with


the operational ability of the organisation and its efficient management of
.a

resources. The financial strength analysis can be made with the help of the
w

following ratios:
w

(1) Debt-equity ratio


(2) Capital gearing ratio
w

(3) Financial leverage


(4) Proprietary ratio and
(5) Interest coverage.

Debt-Equity Ratio:

The debt-equity ratio is determined to ascertain the soundness of


the long-term financial policies of the company. This ratio indicates the
proportion between the shareholders funds (i.e. Tangible net worth) and
the total borrowed funds. Ideal ratio is 1. In other words, the investor may
take debt equity ratio as quite satisfactory if shareholders funds are equal

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to borrowed funds. However, creditors would prefer a low debt-equity


ratio as they are much concerned about the security of their investment.
This ratio can be calculated by dividing the total debt by shareholders
equity. For the purpose of calculation of this ratio, the term shareholders
equity includes share capital, reserves and surplus and borrowed funds
which includes both long-term funds and short-term funds.
Debt
Debt-equity ratio = -----------
Equity

A high ratio indicates that the claims of creditors are higher as compared
to owners funds and a low debt-equity ratio may result in a higher claim
of equity.

m
co
Capital Gearing Ratio: This ratio establishes the relationship
between the fixed interest-bearing securities and equity shares of a
company. It is calculated as follows: s.
bu
Fixed interest-bearing securities
Capital gearing ratio = -------------------------------------
la

Equity shareholders funds


Fixed-interest bearing securities carry with them the fixed rate of dividend
yl

or interest and include preference share capital and debentures. A firm is


lls

said to be highly geared if the lions share of the total capital is in the form
of fixed interest-bearing securities or this ratio is more than one. If this
.a

ratio is less than one, it is said to be low geared. If it is exactly one, it is


w

evenly geared. This ratio must be carefully planned as it affects the firms
w

capacity to maintain a uniform dividend policy during difficult trading


periods that may occur. Too much capital should not be raised by way of
w

debentures, because debentures do not share in business losses.

Financial Leverage Ratio:

Financial leverage results from the presence of fixed financial


charges in the firms income stream. These fixed charges do not vary with
the earnings before interest and tax (ebit) or operating profits. They have
to be paid regardless of the amount of earnings before interest and taxes
available to pay them. After paying them, the operating profits (ebit)
belong to the ordinary shareholders. Financial leverage is concerned
with the effects of changes in earnings before interest and taxes on the

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earnings available to equity holders. It is defined as the ability of a firm


to use fixed financial charges to magnify the effects of changes in ebit
on the firms earning per share. Financial leverage and trading on equity
are synonymous terms. The ebit is calculated by adding back the interest
(interest on loan capital + interest on long term loans + interest on other
loans) and taxes to the amount of net profit. Financial leverage ratio is
calculated by dividing ebit by ebt (earnings before tax). Neither a very high
leverage nor a very low leverage represents a sound picture.
(ebit ebt).

Proprietary Ratio:

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This ratio establishes the relationship between the proprietors

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funds and the total tangible assets. The general financial strength of a firm
can be understood from this ratio. The ratio is of particular importance to
s.
the creditors who can find out the proportion of shareholders funds in the
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capital assets employed in the business. A high ratio shows that a concern
is less dependent on outside funds for capital. A high ratio suggests sound
la

financial strength of a firm due to greater margin of owners funds against


outside sources of finance and a greater margin of safety for the creditors.
yl

A low ratio indicates a small amount of owners funds to finance total


lls

assets and more dependence on outside funds for working capital. In the
form of formula this ratio can be expressed as:-
.a

Net Worth
w

Proprietary Ratio = --------------


w

Total Assets
w

Interest Coverage:

This ratio measures the debt servicing capacity of a firm in so far as


fixed interest on long-term loan is concerned. It is determined by dividing
the operating profits or earnings before interest and taxes (ebit) by the
fixed interest charges on loans. Thus,
EBIT
Interest Coverage = ----------
Interest

It should be noted that this ratio uses the concept of net profits

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before taxes because interest is tax-deductible so that tax is calculated after


paying interest on long-term loans. This ratio, as the name suggests, shows
how many times the interest charges are covered by the ebit out of which
they will be paid. In other words, it indicates the extent to which a fall in
ebit is tolerable in the sense that the ability of the firm to service its debts
would not be adversely affected. From the point of view of creditors, the
larger the coverage, the greater the ability of the firm to handle fixed-
charge liabilities and the more assured the payment of interest to the
creditors. However, too high a ratio may imply unused debt capacity. In
contrast, a low ratio is danger signal that the firm is using excessive debt
and does not have the ability to offer assured payment of interest to the
creditors.

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2.2.3.7 Fixed Assets Analysis

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The successful operation of a business generally requires some
s.
assets of fixed character. These assets are used primarily in producing
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goods and in operating the business. With the help of these, raw materials
are converted into finished products. Fixed assets are not meant for sale
la

and are kept as a rule permanently in the business in order to carry on day-
to-day operations.
yl
lls

Analysis of fixed assets is very important from investors point of


view because investors are more concerned with long term assets. Fixed
.a

assets are properties of non-current nature which are acquired to provide


w

facilities to carry on business. They include land, building, equipment,


w

furniture, etc. They are generally shown in balance sheet by aggregating


them into groups of gross block as reduced by the accumulated amount of
w

depreciation till date. Investment in fixed assets is of a permanent nature


and therefore should be financed by owners funds (permanent sources
of funds). The owners funds should be sufficient to provide for fixed
assets. Fixed assets are generally financed by owners equity and long-term
borrowings. The long-term borrowings are in the form of long-term loans
and of almost permanent nature. Under such a situation it becomes more
or less irrelevant to relate the fixed assets with only the owners equity.
Therefore, the analysis of the source of financing of fixed assets has been
done with the help of the following ratios:-
(a) Fixed Assets To Net Worth
(b) Fixed Assets To Long-Term Funds

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Fixed Assets To Net Worth: in the words of anil b.roy choudhary, this ratio
indicates the relationship between net worth (i.e. Shareholders funds) and
investments in net fixed assets (i.e. Gross block minus depreciation).

The higher the ratio the lesser would be the protection to creditors. If the
ratio is less than 1, it indicates that the net worth exceeds fixed assets. It will
further indicate that the working capital is partly financed by shareholders
funds. If the ratio exceeds 1, it would mean that part of the fixed assets has
been provided by creditors. The formula for derivation of this ratio is:-
Net Fixed Assets
Fixed Assets To Net Worth Ratio = ------------------
Net Worth

m
Fixed Assets To Long-Term Funds: this ratio establishes the

co
relationship
Between the fixed assets and long-term funds and it is obtained by the
formula: s.
bu
Fixed Assets
FIXED ASSET RATIO = --------------------
la

Long-Term Funds
yl

The ratio should be less than one. If it is less than one, it shows that
lls

a part of the working capital has been financed through long-term funds.
This is desirable because a part of working capital termed as core working
.a

capital is more or less of a fixed nature. The ideal ratio is 0.67.


w
w

If this ratio is more than one, it indicates that a part of current


liability is invested in long-term assets. This is a dangerous position. Fixed
w

assets include net fixed assets i.e. Original cost less depreciation to date
and trade investments including shares in subsidiaries. Long-term funds
include share capital, reserves and long-term borrowings.

2.2.3.8 Analysis Of Turnover (Or) Analysis Of Efficiency

Turnover ratios also referred to as activity ratios are concerned


with measuring the efficiency in asset management. Sometimes, these
ratios are also called as efficiency ratios or asset utilisation ratios. The
efficiency with which the assets are used would be reflected in the speed
and rapidity with which assets are converted into sales. The greater the rate

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of turnover or conversion, the more efficient the utilisation/management,


other things being equal. For this reason such ratios are also designated as
turnover ratios. Turnover is the primary mode for measuring the extent of
efficient employment of assets by relating the assets to sales. An activity
ratio may, therefore, be defined as a test of the relationship between sales
(more appropriately with cost of sales) and the various assets of a firm.
Depending upon the various types of assets, there are various types of
activity ratios. Some of the more widely used turnover ratios are:-
Fixed Assets Turnover Ratio
Current Assets Turnover Ratio
Working Assets Turnover Ratio
Inventory (Or Stock) Turnover Ratio
Debtors Turnover Ratio

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Creditors Turnover Ratio

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Fixed Assets Turnover Ratio:
s.
bu
The fixed assets turnover ratio measures the efficiency with which
the firm is utilising its investment in fixed assets, such as land, building,
la

plant and machinery, furniture, etc. It also indicates the adequacy of sales
in relation to investment in fixed assets. The fixed assets turnover ratio
yl

is sales divided by the net fixed assets (i.e., the depreciated value of fixed
lls

assets).
Sales
.a

Fixed Assets Turnover Ratio = ----------------


w

Net Fixed Assets


w

The turnover of fixed assets can provide a good indicator for judging the
efficiency with which fixed assets are utilised in the firm. A high fixed assets
w

turnover ratio indicates efficient utilisation of fixed assets in generating


operating revenue. A low ratio signifies idle capacity, inefficient utilisation
and management of fixed assets.

Current Assets Turnover Ratio:

The current assets turnover ratio ascertains the efficiency with


which current assets are used in a business. Professor guthmann observes
that current assets turnover is to give an overall impression of how rapidly
the total investment in current assets is being turned. This ratio is strongly
associated with efficient utilisation of costs, receivables and inventory. A

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higher value of this ratio indicates greater circulation of current assets


while a low ratio indicates a stagnation of the flow of current assets. The
formula for the computation of current assets turnover ratio is:
Sales
Current Assets Turnover Ratio = -----------------
Current Assets

Working Capital Turnover Ratio: this ratio shows the number of


times working capital is turned-over in a stated period. Working capital
turnover ratio reflects the extent to which a business is operating on a
small amount of working capital in relation to sales. The ratio is calculated
by the following formula:-

m
Sales

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Working Capital Turnover Ratio = ----------------------
Net Working Capital
s.
bu
The higher the ratio, the lower is the investment in working capital
and greater are the profits. However, a very high turnover of working capital
la

is a sign of over trading and may put the firm into financial difficulties.
On the other hand, a low working capital turnover ratio indicates that
yl

working capital is not efficiently utilised.


lls
.a

Inventory Turnover Ratio:


w
w

The inventory turnover ratio, also known as stock turnover ratio


normally establishes the relationship between cost of goods sold and
w

average inventory. This ratio indicates whether investment in inventory is


within proper limit or not. In the words of S.C.Kuchal, this relationship
expresses the frequency with which average level of inventory investment
is turned over through operations. The formula for the computation of
this ratio may be expressed thus:
Cost Of Goods Sold
Inventory Turnover Ratio = -------------------------
Average Inventory

In general, a high inventory turnover ratio is better than a low


ratio. A high ratio implies good inventory management. A very high

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ratio indicates under-investment in, or very low level of inventory which


results in the firm being out of stock and incurring high stock-out cost.
A very low inventory turnover ratio is dangerous. It signifies excessive
inventory or over-investment in inventory. A very low ratio may be the
results of inferior quality goods, over-valuation of closing inventory, stock
of unsaleable/obsolete goods.

Debtors Turnover Ratio And Collection Period:

One of the major activity ratios is the receivables or debtors turnover


ratio. Allied and closely related to this is the average collection period. It
shows how quickly receivables or debtors are converted into cash. In other
words, the debtors turnover ratio is a test of the liquidity of the debtors of

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a firm. The liquidity of a firms receivables can be examined in two ways:

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(i) debtors/receivables turnover and (ii) average collection period. The
debtors turnover shows the relationship between credit sales and debtors
of a firm. Thus, s.
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Net Credit Sales
Debtors Turnover Ratio = ---------------------
la

Average Debtors
yl

Net credit sales consists of gross credit sales minus returns if any,
lls

from the customers. Average debtors is the simple average of debtors at the
beginning and at the end of the year.
.a
w

The second type of ratio measuring the liquidity of a firms debtors


w

is the average collection period. This ratio is, in fact, interrelated with and
dependent upon, the receivables turnover ratio. It is calculated by dividing
w

the days in a year by the debtors turnover. Thus,

Days In Year
Average Collection Period = --------------------
Debtors Turnover

This ratio indicates the speed with which debtors/accounts


receivables are being collected. The higher the turnover ratio and shorter
the average collection period, the better the trade credit management and
better the liquidity of debtors. On the other hand, low turnover ratio and

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long collection period reflects that payments by debtors are delayed. In


general, short collection period (high turnover ratio) is preferable.

Creditors Turnover Ratio And Debt Payment Period:

Creditors turnover ratio indicates the speed with which the


payments for credit purchases are made to the creditors. This ratio can be
computed as follows:-
Average Accounts Payable
Creditors Turnover Ratio = -----------------------------
Net Credit Purchases
The term accounts payable include trade creditors and bills payable.
A high ratio indicates that creditors are not paid in time while a low ratio

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gives an idea that the business is not taking full advantage of credit period

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allowed by the creditors.

s.
Sometimes, it is also required to calculate the average payment period or
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average age of payables or debt period enjoyed to indicate the speed with
which payments for credit purchases are made to creditors. It is calculated
la

as:
Days In A Year
yl

Average Age Of Payables = --------------------------


lls

Creditors Turnover Ratio


.a

Both the creditors turnover ratio and the debt payment period
w

enjoyed ratio indicate about the promptness or otherwise in making


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payment for credit purchases. A higher creditors turnover ratio or lower


credit period enjoyed ratio signifies that the creditors are being paid
w

promptly.

2.2.3.9 Analysis Of Liquidity Position

The liquidity ratios measure the ability of a firm to meet its short-
term obligations and reflect the short-term financial strength/solvency of
a firm. The term liquidity is described as convertibility of assets ultimately
into cash in the course of normal business operations and the maintenance
of a regular cash flow. A sound liquid position is of primary concern to
management from the point of view of meeting current liabilities as and
when they mature as well as for assuring continuity of operations. Liquidity

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position of a firm depends upon the amount invested in current assets


and the nature of current assets. The under mentioned ratios are used to
measure the liquidity position:-
current ratio
liquid (or) quick ratio
cash to current assets ratio
cash to working capital ratio

Current Ratio:

The most widely used measure of liquid position of an enterprise


is the current ratio, i.e., the ratio of the firms current assets to current
liabilities. It is calculated by dividing current assets by current liabilities:

m
Current Assets

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Current Ratio = -------------------
Current Liabilities
s.
The current assets of a firm represent those assets which can be
bu
in the ordinary course of business, converted into cash within a short
period of time, normally not exceeding one year and include cash and
la

bank balance, marketable securities, inventory of raw materials, semi-


finished (work-in-progress) and finished goods, debtors net of provision
yl

for bad and doubtful debts, bills receivable and pre-paid expenses. The
lls

current liabilities defined as liabilities which are short-term maturing


obligations to be met, as originally contemplated, within a year, consist of
.a

trade creditors, bills payable, bank credit, provision for taxation, dividends
w

payable and outstanding expenses. N.l.hingorani and others observe:


w

current ratio is a tool for measuring the short-term stability or ability


of the company to carry on its day-to-day work and meet the short-term
w

commitments earlier. Generally 2:1 is considered ideal for a concern i.e.,


current assets should be twice of the current liabilities. If the current assets
are two times of the current liabilities, there will be no adverse effect on
business operations when the payment of current liabilities is made. If
the ratio is less than 2, difficulty may be experienced in the payment of
current liabilities and day-to-day operations of the business may suffer. If
the ratio is higher than 2, it is very comfortable for the creditors but, for
the concern, it indicates idle funds and lack of enthusiasm for work.

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Liquid (Or) Quick Ratio: liquid (or) quick ratio is a measurement of a


firms ability to convert its current assets quickly into cash in order to meet
its current liabilities. It is a measure of judging the immediate ability of the
firm to pay-off its current obligations. It is calculated by dividing the quick
assets by current liabilities:
Quick Assets
Liquid Ratio = ---------------------
Current Liabilities

The term quick assets refers to current assets which can be converted
into cash immediately or at a short notice without diminution of value.
Thus quick assets consists of cash, marketable securities and accounts
receivable. Inventories are excluded from quick assets because they are

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slower to convert into cash and generally exhibit more uncertainty as to

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the conversion price.

s.
This ratio provides a more stringent test of solvency. 1:1 ratio is
bu
considered ideal ratio for a firm because it is wise to keep the liquid assets
atleast equal to the current liabilities at all times.
la

Cash To Current Assets Ratio:


yl
lls

Efficient management of the inflow and outflow of cash plays a


crucial role in the overall performance of a business. Cash is the most
.a

liquid form of assets which safeguards the security interest of a business.


w

Cash including bank balances plays a vital role in the total net working
w

capital. The ratio of cash to working capital signifies the proportion of


cash to the total net working capital and can be calculated by dividing the
w

cash including bank balance by the working capital. Thus,


Cash
Cash To Working Capital Ratio = --------------------
Working Capital

Cash is not an end in itself, it is a means to achieve the end.


Therefore, only a required amount of cash is necessary to meet day-to-day
operations. A higher proportion of cash may lead to shrinkage of profits
due to idleness of resources of a firm.

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2.2.3.10 Analysis Of Profitability

Profitability is a measure of efficiency and control. It indicates


the efficiency or effectiveness with which the operations of the business
are carried on. Poor operational performance may result in poor sales
and therefore low profits. Low profitability may be due to lack of control
over expenses resulting in low profits. Profitability ratios are employed
by management in order to assess how efficiently they carry on business
operations. Profitability is the main base for liquidity as well as solvency.
Creditors, banks and financial institutions are interested in profitability
ratios since they indicate liquidity or capacity of the business to meet
interest obligations and regular and improved profits enhance the long term
solvency position of the business. Owners are interested in profitability for

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they indicate the growth and also the rate of return on their investments.

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The importance of measuring profitability has been stressed by Hingorani,
Ramanathan And Grewal in these words: a measure of profitability is the
overall measure of efficiency. s.
bu
An appraisal of the financial position of any enterprise is incomplete
la

unless its overall profitability is measured in relation to the sales, assets,


capital employed, net worth and earnings per share. The following ratios
yl

are used to measure the profitability position from various angles:


lls

Gross Profit Ratio


Net Profit Ratio
.a

Return On Capital Employed


w

Operating Ratio
w

Operating Profit Ratio


Return On Owners Equity
w

E arnings Per Share


Dividend Pay Out Ratio

Gross Profit Ratio:

The gross profit ratio or gross profit margin ratio expresses the
relationship of gross profit on sales / net sales. B.r.rao opines that gross
profit margin ratio indicates the gross margin of profits on the net sales
and from this margin only, all expenses are met and finally net income
emerges. The basic components for the computation of this ratio are
gross profits and net sales. `net sales means total sales minus sales returns

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and `gross profit means the difference between net sales and cost of goods
sold. The formula used to compute gross profit ratio is:
Gross Profit
Gross Profit Ratio = ------------------ X 100
Sales

Gross profit ratio indicates to what extent the selling prices of


goods per unit may be reduced without incurring losses on operations. A
low gross profit ratio will suggest decline in business which may be due to
insufficient sales, higher cost of production with the existing or reduced
selling price or the all-round inefficient management. A high gross profit
ratio is a sign of good and effective management.

m
Net Profit Ratio:

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Net profit is a good indicator of the efficiency of a firm. Net profit
s.
ratio or net profit margin ratio is determined by relating net income after
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taxes to net sales. Net profit here is the balance of profit and loss account
which is arrived at after considering all non-operating incomes such as
la

interest on investments, dividends received, etc. And non-operating


expenses like loss on sale of investments, provisions for contingent
yl

liabilities, etc. This ratio indicates net margin earned on a sale of rs.100.
lls

The formula for calculating the ratio is:


.a

Net Profit
w

Net Profit Ratio = ---------------- X 100


w

Sales
w

This ratio is widely used as a measure of overall profitability and is


very useful for proprietors. A higher ratio indicates better position.

Return On Capital Employed:

The prime objective of making investments in any business is to


obtain satisfactory return on capital invested. Hence, the return on capital
employed is used as a measure of success of a business in realising this
objective. Otherwise known as return on investments, this is the overall
profitability ratio. It indicates the percentage of return on capital employed
in the business and it can be used to show the efficiency of the business as

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a whole. The formula for calculating the ratio is:

Operating Profit
Return On Capital Employed = --------------------- X 100
Capital Employed
The term capital employed means [share capital + reserves and
surplus + long term loans] minus [non-business assets + fictitious assets]
and the term operating profit means profit before interest and tax. The
term `interest means interest on long-term borrowings. Non-trading
income should be excluded for the above purpose. A higher ratio indicates
that the funds are invested profitably.

Operating Ratio:

m
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This ratio establishes the relationship between total operating
expenses and sales. Total operating expenses includes cost of goods sold
s.
plus other operating expenses. A higher ratio indicates that operating
bu
expenses are high and the profit margin is less and therefore lower the ratio,
better is the position. The operating ratio is an index of the efficiency of
la

the conduct of business operations. An ideal norm for this ratio is between
75% to 85% in a manufacturing concern. The formula for calculating the
yl

operating ratio is thus:


lls

Cost Of Goods Sold + Operating Experience


.a

Operating Ratio = ----------------------------------------------------- X 100


w

Sales
w

Operating Profit Ratio: this ratio indicates net-margin earned on a sale of


w

rs.100. It is calculated as follows:


Net Operating Profit
Operating Profit Ratio = ------------------------- X 100
Sales

The operating profit ratio helps in determining the efficiency


with which affairs of the business are being managed. An increase in the
ratio over the previous period indicates improvement in the operational
efficiency of the business provided the gross profit ratio is constant.
Operating profit is estimated without considering non-operating income
such as profit on sale of fixed assets, interest on investments and non-

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operating expenses such as loss on sale of fixed assets. This is thus, an


effective tool to measure the profitability of a business concern.

Return On Owners Equity (Or) Shareholders Fund (Or) The Net Worth:

The ratio of return on owners equity is a valuable measure for judging


the profitability of an organisation. This ratio helps the shareholders of a
firm to know the return on investment in terms of profits. Shareholders
are always interested in knowing as to what return they earned on their
invested capital since they bear all the risk, participate in management and
are entitled to all the profits remaining after all outside claims including
preference dividend are met in full. This ratio is computed as a percentage
by using the formula:

m
co
Net Profit After Interest And Tax
s.
Return On Owners Equity = ------------------------------------------ X 100
bu
Owners Equity (Net Worth)
la

This is the single most important ratio to judge whether the firm
yl

has earned a satisfactory return for its equity-shareholders or not. A higher


lls

ratio indicates the better utilisation of owners fund and higher productivity.
A low ratio may indicate that the business is not very successful because of
.a

inefficient and ineffective management and over investment in assets.


w
w

Earnings Per Share (EPS):


w

The profitability of a firm from the point of view of the ordinary


shareholders is analysed through the ratio `EPS. It measures the profit
available to the equity shareholders on a per share basis, i.e. The amount
that they can get on every share held. It is calculated by dividing the profits
available to the shareholders by the number of the outstanding shares. The
profits available to the ordinary shareholders are represented by net profit
after taxes and preference dividend.
Net Profit After Tax Preference Dividend
Earnings Per Share = ----------------------------------------------------
Number Of Equity Shares

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This ratio is an important index because it indicates whether the


wealth of each shareholder on a per-share basis has changed over the
period. The performance and prospects of the firm are affected by eps.
If eps increases, there is a possibility that the company may pay more
dividend or issue bonus shares. In short, the market price of the share of a
firm will be affected by all these factors.

Dividend Pay Out Ratio:

This ratio measures the relationship between the earnings belonging


to the ordinary shareholders and the dividend paid to them. In other words,
the dividend pay out ratio shows what percentage share of the net profits
after taxes and preference dividend is paid out as dividend to the equity

m
shareholders. It can be calculated by dividing the total dividend paid to the

co
owners by the earnings available to them. The formula for computing this
ratio is:
Dividend Per Equity Share s.
bu
Dividend Payout Ratio = -------------------------------
Earnings Per Share
la

This ratio is very important from shareholders point of view as its tells
him that if a firm has used whole, or substantially the whole of its earnings
yl

for paying dividend and retained nothing for future growth and expansion
lls

purposes, then there will be very dim chances of capital appreciation in


the price of shares of such firms. In other words, an investor who is more
.a

interested in capital appreciation must look for a firm having low payout
w

ratio.
w

2.2.3.11 Analysis Of Operational Efficiency


w

The operational efficiency of an organisation is its ability to utilise


the available resources to the maximum extent. Success or failure of
a business in the economic sense is judged in relation to expectations,
returns on invested capital and objectives of the business concern. There
are many techniques available for evaluating financial as well as operational
performance of a firm. The two important techniques adopted in this study
are:
1. Turnover to capital employed or return on investment (ROI)
2. Financial operations ratio

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Turnover To Capital Employed:

This is the ratio of operating revenue to capital employed. This is


one of the important ratios to find out the efficiency with which the firms
are utilising their capital. It signifies the number of times the total capital
employed was turned into sales volumes. The term capital employed
includes total assets minus current liabilities. The ratio for calculating
turnover to capital employed (in percentage) is:
Operating Revenue
Turnover To Capital Employed = --------------------------- X 100
Capital Employed
The higher the ratio, the better is the position.

m
Financial Operations Ratio:

co
The efficiency of the financial management of a firm is calculated
s.
through financial operations ratio. This ratio is a calculating device of the
bu
cost and the return of financial charges. This ratio signifies a relationship
between net profit after tax and operating profit. The formula for the
la

computation of this ratio is:


yl

Net Profit After Tax


lls

Financial Operations Ratio = --------------------------- X 100


Operating Profit
.a

Here, the term operating profit means sales minus operating expenses. A
w

higher ratio indicates the better financial performance of the firm.


w
w

2.2.3.12 Ratios From Shareholders Point Of View

1. Preference dividend cover: this ratio expresses net profit after tax as so
many times of preference dividend payable. This is calculated as:
Net Profit After Tax
-------------------------
Preference Dividend

2. Equity Dividend Cover: this ratio gives information about net


profit available to equity shareholders. This ratio expresses profit as
number of times of equity dividend payable. This ratio is calculated using

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the following formula:


Net Profit After Tax Preference Dividend
-------------------------------------------------
Equity Dividend
3. Dividend Yield On Equity Shares Or Yield Ratio: this ratio interprets
dividend as a percentage of market price per share. It is calculated as:
Dividend Per Share
--------------------------- X 100
Market Price Per Share
4. Price Earning Ratio: this ratio tells how many times of earnings per
share is the market price of the share of a company. The formula to calculate
this ratio is:
Market Price Per Share

m
---------------------------

co
Earnings Per Share

2.2.3.13 Illustrations s.
bu
Illustration 4: the following are the financial statements of yesye limited
for the year 2005.
la
yl

Balance Sheet As At 31-12-2005


lls

Rs. Rs.
Equity Share Capital 1,00,000 Fixed Assets 1,50,000
.a

General Reserve 90,000 Stock 42,500


w

Profit & Loss Balance 7,500 debtors 19,000


w

Sundry Creditors 35,000 Cash 61,000


6% Debentures 30,000 Proposed
w

Dividends 10,000
2,72,500 2,72,500
---------------------------------------------------------------------------------
Trading And Profit And Loss Account
For The Year Ended 31-12-2005
Rs. Rs.
To Cost Of Goods Sold 1,80,000 By Sales 3 ,00,000
To Gross Profit C/D 1,20,000

3,00,000 3,00,000

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To Expenses 1,00,000 By Gross Profit B/D 1,20,000


To Net Profit 20,000

1,20,000 1,20,000

You are required to compute the following:


1) Current Ratio
2) Acid Test Ratio
3) Gross Profit Ratio
4) Debtors Turnover Ratio
5) Fixed Assets To Net Tangible Worth
6) Turnover To Fixed Assets
Solution:

m
Current Assets

co
1) Current Ratio = ---------------------
Current Liabilities
s.
bu
1,22,500
= ----------- = 2.7:1.
la

45,000
yl

Quick Assets
lls

2) Acid Test Ratio = -------------------


Quick Liabilities
.a
w

80,000
w

= ----------- = 1.8:1.
45,000
w

Gross Profit
3) Gross Profit Ratio = ---------------------- X 100
Sales

1,20,000
= ------------- X 100 = 40%
3,00,000
Net Sales
4) Debtors Turnover Ratio = ---------------------
Average Debtors

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3,00,000
= ------------- = 15.78 Times.
19,000

No. Of Days In The Year


Collection Period = -----------------------------
Debtors Turnover

365
= ----------- = 23 Days
15.78

5) Fixed Asset To Fixed Assets

m
Net Tangible Worth = ----------------------- X 100

co
Proprietors Fund

1,50,000 s.
bu
= ------------- X 100 = 76%
1,97,500
la

Net Sales
yl

6) Turnover To Fixed Assets = ------------------


lls

Fixed Assets
.a

3,00,000
w

= ----------- = 2 Times
w

1,50,000
w

Illustration 5: from the following details prepare a statement of proprietary


fund with as many details as possible.
1) Stock Velocity 6
2) Capital Turnover Ratio 2
3) Fixed Assets Turnover Ratio 4
4) Gross Profit Turnover Ratio 20%
5) Debtors Velocity 2 Months
6) creditors velocity 73 days
Gross profit was rs.60,000. Reserves and surplus amount to 20,000. Closing
stock was rs.5,000 in excess of opening stock.

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Solution:
1. Calculation Of Sales
Gross Profit
Gross Profit Ratio = --------------- X 100 = 20%
Sales

Rs.60,000 20
= --------------- = --------
Sales 100

1
= ---
5

m
Sales: Rs.3,00,000

co
2. Calculation Of Sundry Debtors
Debtors s.
bu
Debtors Velocity = ------------ X 12 Months
Sales
la

Let Debtors Be X
X
yl

2 = ----------- X 12
lls

3,00,000
.a

X 1
w

------------- = ---
w

3,00,000 6
w

X = Rs.50,000

Debtors: Rs.50,000
It Is Assumed That All Sales Are Credit Sales.

3. Calculation Of Stock
Cost Of Goods Sold
Stock Turnover Ratio = --------------------------- =6
= Average Stock
Cost Of Goods Sold = Sales Gross Profit
= Rs.3,00,000 Rs.60,000

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= Rs.2,40,000

Rs.2,40,000
------------------ = 6
Average Stock

Rs.2,40,000
Average Stock = --------------- = Rs.40,000
6
Opening Stock + Closing Stock
Average Stock = --------------------------------------
2
Let Opening Stock Be Rs.X.

m
Then Closing Stock Will Be X + 5,000

co
X + X + 5,000
---------------- = 40,000
2 s.
bu
2X + 5,000
-------------- = 40,000
la

2
Cross Multiplying
yl

2X + 5,000 = 80,000
lls

2X = 80,000 5,000
= 75,000
.a

X = 37,500
w
w

4. Calculation Of Creditors
Total Creditors
w

Creditors Velocity = ------------------------------ X 365


Days Credit Purchases
= 73 Days
Purchase = Cost Of Goods + Closing Stock Opening Stock
= Rs.2,40,000 + 42,500 37,500
= Rs.2,45,000

Let The Creditors Be X


X
-------------- X 365 = 73
2,45,000

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365 X = 2,45,000 X 73

2,45,000 X 73
X = ----------------
365

Creditors = Rs.49,000

5. Calculation Of Fixed Assets


Costs Of Goods Sold
Fixed Assets Turnover Ratio = ----------------------------- = 4
Fixed Assets
Let Fixed Assets Be X

m
2,40,000

co
---------- = 4
X
X = 60,000 s.
bu
Fixed Assets = Rs.60,000
la

6. Shareholders Fund
Cost Of Goods Sold
yl

Capital Turnover Ratio = ----------------------- = 2


lls

Proprietary Fund
.a
w

2,40,000
w

--------------------- =2
Proprietary Fund
w

Proprietary Fund = Rs.1,20,000


Shareholders Fund Includes Share Capital, Profit & Reserve.
Share Capital = Shareholders Fund (Profit + Reserve)
= Rs.1,20,000 Rs.80,000
= Rs.40,000

7. Calculation Of Bank Balance


Shareholders Fund + Current Liabilities = Fixed Assets + Current Assets
Rs.1,20,000 + 49,000 = Rs.60,000 + Current Assets
Current Assets = Rs.1,09,000

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Current Assets = Stock + Debtors + Bank


Bank Balance = Current Assets (Stock +
Debtors)
= Rs.1,09,000 (42,500 + 50,000)
= Rs.1,09,000 92,500
= Rs.16,500

Balance Sheet As On
---------------------------------------------------------------------------------
Liabilities Rs. Assets Rs.
---------------------------------------------------------------------------------
Share Capital 40,000 Fixed Assets 60,000
Reserves & Surplus 20,000 Current Assets:

m
Profit 60,000 Stock 42,500

co
Current Liabilities 49,000 Debtors 50,000
Bank 16,500
---------- s. ------------
bu
1,69,000 1,69,000
---------------------------------------------------------------------------------
la

Illustration 6: The Following Data Is Furnished:


yl

A) Working Capital Rs.45,000


lls

B) Current Ratio 2.5


C) Liquidity Ratio 1.5
.a

D) Proprietary Ratio (Fixed Assets To Proprietary Funds) 0.75


w

E) Overdraft Rs.10,000
w

F) Retained Earnings Rs.30,000


There Are No Long Term Loans And Fictitious Assets.
w

Find Out:
1) Current Assets
2) Current Liabilities
3) Fixed Assets
4) Quick Assets
5) Quick Liabilities
6) Stock
7) Equity
Solution:
Current Assets
Current Assets 2.5

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Current Liability 1.0


---
Working Capital 1.5
If Working Capital Is 1.5, Current Asset Will Be 2.5.
If Working Capital Is Rs.45,000, Current Assets Will Be Rs.75,000
Current Assets = Rs.75,000

Current Liability

Current Liability = Current Assets Working Capital


= Rs.75,000 Rs.45,000
= Rs.30,000
Fixed Assets

m
co
Shareholders Fund+ Current Liabilities = Fixed Assets + Current Assets
Shareholders Fund=Fixed Assets + Current Assets Current Liabilities
s.
= Fixed Assets + Rs.75,000 Rs.30,000
bu
= Fixed Assets + Rs.45,000
Let The Shareholders Fund Be X, Fixed Assets Will Be X
la

X = Rs. X + Rs.45,000
X = Rs.45,000
yl

X = Rs.1,80,000
lls

X = Rs.1,35,000
Fixed Assets = Rs.1,35,000
.a

Shareholders Funds = Rs.1,35,000 + Rs.45,000


w

= Rs.1,80,000
w

Stock
w

Quick Assets
Liquid Ratio = -------------------
Quick Liabilities
Quick Assets = Current Assets Stock
Quick Liabilities = Current Liabilities Bank Overdraft
Let The Value Of Stock Be X.
Quick Assets Rs.75,000 X
-------------------- = ---------------------
Quick Liabilities 30,000 10,000

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75,000 - X
= ------------- = 1.5
20,000
Cross Multiplying
75,000 X = 20,000 X 1.5
75,000 X = 30,000
X = 45,000
Stock = Rs.45,000
Quick Assets = Rs.75,000 Rs.45,000
= Rs.30,000
Quick Liabilities = Rs.20,000

Equity

m
co
Shareholders Fund = Equity + Retained Earnings
Shareholders Fund = Rs.1,80,000 (As Calculated)
Retained Earnings = Rs.30,000 (As Given) s.
bu
Equity = Rs.1,50,000
la

Illustration 7:
yl

From the following balance sheet of dinesh limited calculate (i)


lls

current ratio (ii) liquid ratio (iii) debt-equity ratio (iv) proprietary ratio,
and (v) capital gearing ratio.
.a

Balance Sheet Of Dinesh Limited As On 31-12-2005


w

---------------------------------------------------------------------------------
w

Liabilities Rs. Assets Rs.


---------------------------------------------------------------------------------
w

Equity share capital 10,00,000 goodwill 5,00,000


6% preference capita l 5,00,000 plant & machinery 6,00,000
Reserves 1,00,000 land & buildings 7,00,000
Profit & loss a/c 4,00,000 furniture 1,00,000
Tax provision 1,76,000 stock 6,00,000
Bills payable 1,24,000 bills receivables 30,000
Bank overdraft 20,000 sundry debtors 1,50,000
Sundry creditors 80,000 bank account 2,00,000
12% debentures 5,00,000 short term investment 20,000
------------ ---------
29,00,000 29,00,000
---------------------------------------------------------------------------------

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Current Assets
(I) Current = ------------------------
Ratio Current Liabilities

Stock + Bills Receivables + Debtors + Bank + S.T. Investments


= ----------------------------------------------------------------
S.Creditors + Bills Payable + Bank O.D. + Tax Provision

10,00,000
= ------------ = 2.5 : 1.
4,00,000

Interpretation:

m
co
The current ratio in the said firm is 2.5:1 against a standard ratio
of 2:1. It is a good sign of liquidity. However, the stock is found occupying
s.
60 percent of current assets which may not be easily realisable.
bu
Current Assets Stocks
(II) Liquid Ratio = --------------------------------
la

Current Liabilities
Liquid Assets
yl

= ------------------------
lls

Current Liabilities
.a

4,00,000
w

= ----------
w

4,00,000
= 1:1.
w

Interpretation:

The standard for quick ratio is 1:1. The calculated ratio in case of
dinesh limited is also 1:1. The above two ratios show the safety in respect
of liquidity in the said firm.

Long Term Debt


(III) Debt Equity Ratio = -------------------------------------
Equity Shareholders Fund

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Debentures
= ---------------------------------------------------------------------------
Equity Capital + Preference Capital + Reserves + Profit & Loss A/C

5,00,000
= -------------------------------------------------------
10,00,000 + 5,00,000 + 1,00,000 + 4,00,000
= 1:4.

Interpretation:

Debt-equity ratio indicates the firms long term solvency. It can be

m
observed that the firms long term loans are constituting 25 percent to that

co
of the owners fund. Although such a low ratio indicates better long term
solvency, the less use of debt in capital structure may not enable the firm
to gain from the full stream of leverage effects. s.
bu
Proprietors Funds
(IV) Proprietary Ratio = ---------------------------
la

Total Assets
yl

20,00,000
lls

= ------------ = 20:29
29,00,000
.a
w

Interpretation:
w

Out of total assets, seven-tenths are found financed by owners


w

funds. In other words a large majority of long term funds are well invested
in various long term assets in the firm.
Owners Resources
(V) Capital Gearing Ratio = -------------------------------------------
Fixed-Interest Bearing Resources
Equity Share Capital + Reserves + P&L A/C
= -----------------------------------------------
Preference Capital + Debentures
10,00,000 + 1,00,000 + 4,00,000
= --------------------------------------------
5,00,000 + 5,00,000

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15,00,000
= --------------- = 1.5:1.
10,00,000

Interpretation:

Keeping rs.15 lakhs of equity funds as security, the firm is found to


have mobilised rs.10 lakhs from fixed interest bearing sources. It indicates
that the capital structure is low geared.

Illustration 8:

m
The following are the balance sheet and profit and loss account of

co
sundara products limited as on 31st december 2005.
Profit And Loss Account
To Opening Stock 1,00,000 s. By Sales 8,50,000
bu
Purchases 5,50,000 Closing Stock 1,50,000
Direct Expenses 15,000
la

Gross Profit 3,35,000


------------ ------------
yl

10,00,000 10,00,000
lls

------------ ------------
To Admn. Expenses 50,000 By Gross Profit 3,35,000
.a

Office Establishment 1,50,000 Non-Operating


w

Income 15,000
w

Financial Expenses 50,000


Non-Operating
w

Expenses/Losses 50,000
Net Profit 50,000
----------- -----------
3,50,000 3,50,000
---------------------------------------------------------------------------------

Balance Sheet
Liabilities Rs. Assets Rs.
Equity Share Capital Land & Buildings 1,50,000
(2000 @ 100) 2,00,000 Plant & Machinery 1,00,000
Reserves 1,50,000 Stock In Trade 1,50,000

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Current Liabilities 1,50,000 Sundry Debtors 1,00,000


P&L A/C Balance 50,000 Cash & Bank 50,000
---------- ----------
5,50,000 5,50,000
---------------------------------------------------------------------------------

Calculate Turnover Ratios.

Solution:

m
(I) Share Capital To Turnover Ratio

co
Sales
= ----------------------------------
Total Capital Employed s.
bu
Sales
la

= ------------------------------------------------
Equity + Reserve + P & L A/C Balance
yl
lls

8,50,000
= ----------
.a

4,00,000
w
w

= 2.13 Times.
w

Interpretation:

This turnover ratio indicates that the firm has actually converted
its share capital into sales for about 2.13 times. This ratio indicates the
efficiency in use of capital resources and a high turnover ratio ensures
good profitability on operations on an enterprise.
(ii) fixed assets turnover ratio
Sales
= ---------------------------
Total fixed assets

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Sales
= ------------------------------------
Land + Plant & Machinery

8,50,000
= ------------
2,50,000

= 3.4 times.

Interpretation:

Although fixed assets are not directly involved in the process of

m
generating sales, these are said to back up the production process. A ratio

co
of 3.4 times indicates the efficient utilisation of various fixed assets in this
organisation.
(iii) Net working capital turnover: s.
bu
Sales
= ----------------------------
la

Net Working Capital


yl

Sales
lls

= --------------------------------------------
Current Assets Current Liabilities
.a
w

8,50,000
w

= -----------------------
3,00,000 1,50,000
w

= 5.67 Times.

Interpretation:

Net working capital indicates the excess of current assets financed


by permanent sources of capital. An efficient utilisation of such funds is
of prime importance to ensure sufficient profitability along with greater
liquidity. A turnover ratio of 5.7 times is really appreciable.
(iv) Average Collection Period:

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Credit Sales
Debtors Turnover = -----------------------
Average Debtors
Assuming that 80% of the sales of 8,50,000 as credit sales:
6,80,000
= ------------
1,00,000

= 6.8 times

Average collection period


360 Days
= -------------------------

m
Debtors Turnover

co
360
= ------- s.
bu
6.8
la

= 53 Days
yl

Interpretation:
lls

Average collection period indicates the time taken by a firm in


.a

collecting its debts. The calculated ratio shows that the realisation of cash
w

on credit sales is taking an average period of 53 days. A period of roughly


w

two months indicate that the credit policy is liberal and needs a correction.
w

(v) Stock Turnover Ratio


Cost Of Goods Sold
= ---------------------------
Average Stock
Sales Gross Profit
= ------------------------------------------------
(Opening Stock + Closing Stock) + 2

5,15,000
= ----------
1,25,000

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= 4.12 times.

Interpretation:

Stock velocity indicates the firms efficiency and profitability.


The stock turnover ratio shows that on an average inventory balances are
cleared once in 3 months. Since there is no standard for this ratio, the
period of operating cycle of this firm is to be compared with the industry
average for better interpretation.

Illustration 9:

Comment on the performance of arasu limited from the ratios

m
given below:

co
Industry average Ratios of
Ratios Arasu ltd.
1. Current ratio 2:1 s.
2.5:1
bu
2. Debt-equity ratio 2:1 1:1
3. Stock turnover ratio 9.5 3.5
la

4. Net profit margin ratio 23.5% 15.1%


yl
lls

Solution:
.a

(i) Current Ratio:


w
w

This ratio indicates the liquidity position of a firm. The ability of a


firm in meeting its current liabilities could be understood by this ratio. The
w

calculated results show that the liquidity in arasu limited is even greater
than industry average, showing the safety. However, excess liquidity locks
up the capital in unnecessary current assets.
(ii) Debt-Equity Ratio:

It is an indicator of a firms solvency in terms of its ability to repay


long term loans in time. The calculated ratio shows better solvency of 1:1
indicating that for every one rupee of debt capital, to repay one rupee of
equity base exists in arasu ltd. However, this ratio is not likely to ensure the
leverage benefits that a firm gains by using higher dose of debt.

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(iii) Stock Turnover Ratio:

Stock velocity is an indicator of a firms activeness. It directly


influences the profitability of a firm. The calculated ratio for arasu ltd. Is
very poor when compared to industry average. This poor ratio indicates
the inefficient use of capacities, consequently, the likely low profitability.

(iv) Net Profit Margin Ratio:

Although the firms in a particular industry could sell the product


more or less at same price, the net profits differ among firms due to their
cost of production, excessive administrative and establishment expenses
etc. This picture is found true in case of arasu ltd. A poor profitability of

m
15.1% compared to an industry average of 23.5% may be due to low stock

co
turnover, inefficiency in management, excess overhead cost and excessive
interest burdens.
s.
bu
2.2.3.14 Summary
la

Financial statements by themselves do not give the required


information both for internal management and for outsiders. They must
yl

be analysed and interpreted to get meaningful information about the


lls

various aspects of the concern. Analysing financial statements is a process


of evaluating the relationship between the component parts of the financial
.a

statements to obtain a proper understanding of a firms performance.


w

Financial analysis may be external or internal analysis or horizontal or


w

vertical analysis. Financial analysis can be carried out through a number


of tools like ratio analysis, funds flow analysis, cash flow analysis etc.
w

Among the various tools available for their analysis, ratio analysis is the
most popularly used tool. The main purpose of ratio analysis is to measure
past performance and project future trends. It is also used for inter-firm
and intra-firm comparison as a measure of comparative productivity. The
financial analyst x-rays the financial conditions of a concern by the use of
various ratios and if the conditions are not found to be favourable, suitable
steps can be taken to overcome the limitations.

2.2.3.15 Key Words

Analysis: analysis means methodical classification of the data given

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in the financial statements.

Interpretation: interpretation means explaining the meaning and


significance of the data so classified.

Financial Statements: income statement and balance sheet.


Ratio: the relationship of one item to another expressed in simple
mathematical form is known as a ratio.

Ratio Analysis: the process of computing, determining and presenting the


relationship of items and groups of items in financial statements.

Financial Leverage: the ability of a firm to use fixed financial charges to

m
magnify the effects of changes in ebit on the firms earnings per share.

co
Net Worth: proprietors funds intangible assets fictitious assets.
s.
Debt: both long term and short term liabilities.
bu
Operating Profit: gross profit operating expenses.
la

Equity: proprietors fund.


yl

Capital Employed: net worth + long term liabilities.


lls

2.2.3.16 Self Assessment Questions


.a
w

1. Explain the meaning of the term `financial statements. State their nature
w

and limitations.
2. Explain the different types of financial analysis.
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3. Explain the various tools of financial analysis.


4. Justify the need for analysis and interpretation of financial statements.
5. Collect the annual reports of any public limited company for a period of
5 years. Calculate the trend percentages and prepare a report.
6. What is meant by ratio analysis? Explain its significance in the analysis
and interpretation of financial statements.
7. Explain the importance of ratio analysis in making comparisons between
firms.
8. How are the ratios broadly classified? Explain how ratios are calculated
under each classification.
9. What are the limitations of ratio analysis?

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10. From the below given summary balance sheet, calculate current ratio
and long term solvency ratio.

Balance Sheet As On 31st December 2005


Liabilities Rs. Assets Rs.
Share Capital 4,00,000 Fixed Assets 4,00,000
Long Term Loans 2,00,000 Current Assets 4,00,000
Current Liabilities 2,00,000
---------- -----------
8,00,000 8,00,000
---------------------------------------------------------------------------------
11. From the following trading and profit and loss account and balance
sheet calculate (i) stock turnover ratio (ii) debtors velocity (iii) sales to

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working capital (iv) sales to total capital employed (v) return on investment

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(vi) current ratio (vii) net profit ratio and (viii) operating ratios.

Trading And Profit And Loss Account s.


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Rs. Rs.
To Opening Stock 1,00,000 By Sales 10,00,000
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To Purchase 5,50,000 By Closing Stock 1,50,000


To Gross Profit 5,00,000
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----------- ------------
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11,50,000 11,50,000
By Gross Profit 5,00,000
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Admn. Expenses 1,50,000


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Interest 30,000
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Selling Expenses 1,20,000


Net Profit 2,00,000
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5,00,000 5,00,000
---------------------------------------------------------------------------------

Balance Sheet
Share capital 10,00,000 Land & Building 5,00,000
Profit & loss a/c 2,00,000 Plant & Machinery 3,00,000
S.creditors 2,50,000 Stock 1,50,000
Bills payable 1,50,000 Debtors 1,50,000
Bills receivable 1,25,000
Cash in hand 1,75,000
Furniture 2,00,000

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16,00,000 16,00,000
---------------------------------------------------------------------------------
12. Triveni engineering limited has the following capital structure:
9% preference shares of rs.100 each 10,00,000
Equity shares of rs.10 each 40,00,000
-----------
50,00,000
-----------
The following information relates to the financial year just ended:
Profit after taxation 22,00,000
Equity dividend paid 20%
Market price of equity shares rs.20 each
You are required to find

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(A) Dividend Yield On Equity Shares

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(B) The Cover For Preference And Equity Dividend
(C) Earnings Per Share
(D) P/E Ratio s.
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2.2.3.17 Key To Self Assessment Questions (For Problems Only)
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Q.no.10: current ratio: 2:1; debt equity ratio: 1:2 or 1:1.


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Q.no.11: (i) 4 times; (ii) 100 days; (iii) 5 times; (iv) 0.83 times; (v)
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19.17%; (vi) 1.5:1; (vii) 20%; (viii) 77%.


Q.no.12: (a) 10%; (b) 24.4 times and 2.6 times (c) rs.5.275; (d) 3.8
.a

times.
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2.2.3.18 Case Analysis


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The following figures are extracted from the balance sheets of a


Company:

2002-03 2003-04 2004-05


Rs. Rs. Rs.
Assets

Buildings 12,000 10,000 20,000


Plant And Equipment 10,000 15,000 10,000
Stock 50,000 50,000 70,000

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Debtors 30,000 50,000 60,000


-----------------------------------------------
1,02,000 1,25,000 1,60,000
-----------------------------------------------
Liabilities

Paid up capital (rs.10 shares 56,000 56,000 56,000


Rs.7-50 paid up)
Profit & loss a/c 10,000 13,000 15,000
Trade creditors 11,000 26,000 39,000
Bank 25,000 30,000 50,000
1,02,000 1,25,000 1,60,000

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Sales 1,00,000 1,50,000 1,50,000

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Gross profit 25,000 30,000 25,000
Net profit 5,000 7,000 5,000
Dividend paid 4,000 s.
4,000 3,000
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The opening stock at the beginning of the year 2002-03 was rs.4,000.
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As a financial analyst comment on the comparative short-term, activity,


solvency, profitability and financial position of the company during the
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three year period.


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Solution:
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To test the short-term solvency the following ratios are calculated


for three years:
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I. Current ratio and


Ii. Quick ratio

(i) Current Ratio:


2002-03 2003-04 2004-05
Current assets 80,000 1,00,000 1,30,000
------------------------ -------- ----------- ---------
Current liabilities 36,000 56,000 89,000
2.22:1 1.80:1 1.46:1
(ii) Quick Ratio:
2002-03 2003-04 2004-05

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Quick assets (debtors) 30,000 50,000 60,000


------------------------------- ------- -------- --------
Quick liabilities (creditors) 11,000 26,000 39,000
2.7:1 1.9:1 1.5:1

As the standard for current ratio is 2:1 the working capital position
of the company has weakened in the 2nd year and 3rd year. However the
quick ratio for all the three years is well above the standard of 1:1. Thus it
can be said that the short term solvency position of the company shows a
mixed trend.

Activity Ratios:

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To test the operational efficiency of the company the following

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ratios are calculated. Debtors turnover ratio and inventory turnover ratio.

Debtors Turnover Ratio: s.


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2002-03 2003-04 2004-05
Sales 1,00,000 1,50,000 1,50,000
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-------------------- ---------- ---------- ---------


Average Debtors 30,000 40,000 55,000
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3.33 Times 3.75 Times 2.73 Times


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The sales as a number of times of debtors has improved in the year 2003-
04 but has deteriorated in the year 2004-05.
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Inventory Turnover Ratio:


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2002-03 2003-04 2004-05


Cost Of Goods Sold (Sales G.P.) 75,000 1,20,000 1,25,000
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------------------------------------- --------- ---------- ---------


O.S + C.S 27,000 50,000 60,000
Average Stock (--------------)
2 2.78 Times 2.40 Times 2.08 Times

Though there is no standard for inventory turnover ratio, higher the ratio,
better is the activity level of the concern. From this angle the ratio has
come down gradually during the three year period indicating slow moving
of stock.

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Profitability Ratios:
To analyse the profitability position of the company, gross profit
ratio and net profit ratio are calculated.

Gross Profit Ratio:

2002-03 2003-04 2004-05


Gross Profit 25,000 30,000 25,000
-------------- X 100 ----------- ---------- ----------
Sales 1,00,000 1,50,000 1,50,000
25% 20% 16.7%

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Net Profit Ratio:

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2002-03 2003-04 2004-05
Net Profit 5,000 7,000 5,000
------------ X 100 ---------- s.
---------- ---------
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Sales 1,00,000 1,50,000 1,50,000
5% 4.7% 3.3%
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The profitability ratios show that there is steady decline in the profitability
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of the concern during the period. One reason for this declining profitability
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among others, is the low and decreasing inventory turnover ratio.


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Financial Position: here the long term solvency position of the concern is
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analysed by calculating debt/equity ratio and debt/asset ratio.


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Debt/Equity Ratio:
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2002-03 2003-04 2004-05


Debt 36,000 56,000 89,000
--------- -------- -------- --------
Equity 66,000 69,000 71,000
0.545:1 0.812:1 1.254:1
Debt/Asset Ratio:
2002-03 2003-04 2004-05
Debt 36,000 56,000 89,000
--------- --------- ----------- ---------
Assets 1,02,000 1,25,000 1,61,000
0.35:1 0.448:1 0.556:1

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Debt equity ratio expresses the existence of debt for every re.1 of
equity. From this standpoint the share of debt in comparison to equity is
increasing year after year and in the last year the debt is even more than
equity. Debt asset ratio gives how much of assets have been acquired using
debt funds. The calculation of this ratio reveals that in the 1st year 35% of
assets were purchased using debt funds which has increased to 44.8% in
the 2nd year and 55.6% in the 3rd year. Thus both the ratios reveal that
the debt component in the capital structure is increasing which has far
reaching consequences.

2.2.3.19 Books For Further Reading

1. James Jiambalvo: Managerial Accounting, John Wiley & Sons.

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2. Khan & Jain: Management Accounting, Tata Mcgraw Hill Publishing

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Co.
3. J.Made Gowda: Management Accounting, Himalaya Publishing House.
4. s.
S.N.Maheswari: Management Accounting, Sultan Chand & Sons.
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5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting For Management,
6. S.Chand & Co. New Delhi.
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*****
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Unit-III

Lesson 3.1: Funds Flow Analysis And Cash Flow Analysis

3.1.1 Introduction

At the end of each accounting period, preparation and presentation


of financial statements are undertaken with an objective of providing as
much information as possible for the public. The balance sheet presents a
snapshot picture of the financial position at a given point of time and the
income statement shows a summary of revenues and expenses during the

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accounting period. Though these are significant statements especially in

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terms of the principal goals of the enterprise, yet there is a need for one
more statement which will indicate the changes and movement of funds
s.
between two balance sheet dates which are not clearly mirrored in the
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balance sheet and income statement. That statement is called as funds flow
statement. The analysis which studies the flow and movement of funds
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is called as funds flow analysis. Similarly one more statement has to be


prepared known as cash flow statement. This requires the doing of cash
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flow analysis. The focus of cash flow analysis is to study the movement and
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flow of cash during the accounting period. This lesson deals at length both
the analyses.
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3.1.2 Objectives
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After reading this lesson, the reader should be able to


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understand the concept of funds and flow.


evaluate the changes in working capital in an organization.
ascertain the sources and uses of funds from a given financial
statement.
prepare fund flow statement.
understand the concepts of cash and cash flow.
understand the cash flow analysis.
prepare cash flow statement.

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3.1.3 Contents
3.3.3.1 Concept Of Funds
3.3.3.2. Flow Of Funds
3.3.3.3 Importance And Utility Of Funds Flow Analysis
3.3.3.4 Preparation Of Funds Flow Statement
3.3.3.5 Illustrations
3.3.3.6 Meaning Of Concepts Of Cash, Cash Flow And Cash Flow
Analysis
3.3.3.7 Cash Flow Statement
3.3.3.8 Calculation Of Cash From Operations
3.3.3.9 Utility Of Cash Flow Analysis
3.3.3.10 Cash Flow Analysis Vs. Funds Flow Analysis
3.3.3.11 Illustrations

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3.3.3.12 Summary

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3.3.3.13 Key Words
3.3.3.14 Self Assessment Questions
s.
3.3.3.15 Key To Self Assessment Questions
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3.3.3.16 Case Analysis
3.3.3.17 Books For Further Reading
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3.1.3.1 Concept Of Funds


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How are funds defined? Perhaps the most ambiguous aspect of funds
flow statement is understanding what is meant by funds. Unfortunately
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there is no general agreement as to precisely how funds should be defined.


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To a lay man the concept of funds means `cash. According to a few, `funds
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means `net current monetary assets arrived at by considering current


assets (cash + marketable securities + short term receivables) minus short
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term obligations. A third view, which is the most acceptable one, is that
concept of funds means `working capital and in this lesson the term
`funds is used in the sense of
Working capital.

Working Capital Concept Of Funds

The excess of an enterprises total current assets over its total current
liabilities at some point of time may be termed as its net current assets or
working capital. To illustrate this, let us assume that on the balance sheet
date the total current assets of an enterprise are rs.3,00,000 and its total

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current liabilities are rs.2,00,000. Its working capital on that date will be
rs.3,00,000 rs.2,00,000 = rs.1,00,000. It follows from the above, that any
increase in total current assets or any decrease in total current liabilities
will result in a change in working capital.

3.1.3.2 Flow Of Funds

The term `flow means change and therefore, the term `flow of
funds means `change in funds or `change in working capital. According
to manmohan and goyal, the flow of funds refers to movement of funds
described in terms of the flow in and out of the working capital area. In
short, any increase or decrease in working capital means `flow of funds.
Many transactions which take place in a business enterprise may increase

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its working capital, may decrease it or may not effect any change in it. Let

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us consider the following examples.

(i) Purchased Machinery For Rs.3,00,000: s.


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The effect of this transaction is that working capital decreases by
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3,00,000 as cash balance is reduced. This change (decrease) in working


capital is called as application of funds. Here the accounts involved are
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current assets (cash a/c) and fixed asset (machinery a/c).


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(ii) Issue Of Share Capital Of Rs.10,00,000:


.a
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This transaction will increase the working capital as cash balance


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increases. This change (increase) in working capital is called as source of


funds. Here the two accounts involved are current assets (cash a/c) and
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long-term liability (share capital a/c).

(iii) Sold Plant For Rs.3,00,000:

This transaction will have the effect of increasing the working


capital by rs.3,00,000 as the cash balance increases by rs.3,00,000. It is a
source of funds. Here the accounts involved are current assets (cash a/c)
and fixed assets (plant a/c).

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(iv) Redeemed Debentures Worth Rs.1,00,000:

This transaction has the effect of reducing the working capital, as


the redemption of debentures results in reduction in cash balance. Hence
this is an example of application of funds. The two accounts affected by this
transaction are current assets (cash a/c) and long-term liability (debenture
a/c).

(v) Purchased Inventory Worth Rs.10,000:

This transaction results in decrease in cash by rs.10,000 and increase


in stock by rs.10,000 thereby keeping the total current assets at the same
figure. Hence there will be no change in the working capital (there is no

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flow of funds in this transaction). Both the accounts affected are current

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assets.

s.
(vi) Notes Payable Drawn By Creditors Accepted For Rs.30,000:
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The effect of this transaction on working capital is nil as it results
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in increase in notes payable (a current liability) and decreases the creditors


(another current liability). Since there is no change in total current
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liabilities there is no flow of funds.


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(vii) Building Purchased For Rs.30,00,000 And Payment Is Made By


.a

Shares:
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This transaction will not have any impact on working capital as it


does not result in any change either in the current asset or in the current
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liability. Hence there is no flow of funds. The two accounts affected are
fixed assets (building a/c) and long term liabilities (capital a/c).
From the above series of examples, we arrive at the following rules on flow
of funds:

I. There Will Be Flow Of Funds Only When There Is A Cross-Transaction


I.E., Only When The Transaction Involves:

C
urrent Assets And Fixed Assets E.G., Purchase Of Machinery
For Cash (Application Of Funds) Or Sale Of Plant For A Cash
(Source Of Funds).

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C urrent Assets And Capital, E.G., Issue Of Shares (Source Of


Funds).
Current Assets And Long Term Liabilities, E.G., Redemption Of
Debentures In Cash (Application Of Funds).
Current Liabilities And Long-Term Liabilities, E.G., Creditors
Paid Off In Debentures Or Shares (Source Of Funds).
Current Liabilities And Fixed Assets, E.G., Building Transferred
To Creditors In Satisfaction Of Their Claims (Source Of Funds).

Ii. There Will Be No Flow Of Funds When There Is No Cross Transaction


I.E., When The Transaction Involves:

C
urrent Assets And Current Assets, E.G., Inventory Purchased

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For Cash.

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C urrent Liabilities And Current Liabilities, E.G., Notes Payable
Issued To Creditors.
s.
Current Assets And Current Liabilities, E.G., Payments Made To
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Creditors.
Fixed Assets And Long Term Liabilities, E.G., Building Purchased
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And Payment Made In Shares Or Debentures.


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(a) Sources And Application Of Funds: the following are the main sources
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of funds:
(i) Funds From Operations: the operations of the business generate
.a

revenue and entail expenses. Revenues augment working capital and


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expenses other than depreciation and other amortizations. The following


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adjustments will be required in the figures of net profit for finding out the
real funds from operations:
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Funds From Operations


Net profit for the year x x x
Add*: depreciation of fixed assets x x x
Preliminary expenses, goodwill, etc.
Written off x x x
Loss on sale of fixed assets x x x
Transfers to reserve x x x
Less: profit on sale or revaluation x x x
Dividends received, etc. X x x
Funds from operations x x x

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* these items are added as they do not result in outflow of funds. In case of
`net loss for the year these items will be deducted.
(ii) Issue Of Share Capital: an issue of share capital results in an
inflow of funds.

(iii) Long-Term Borrowings: when a long-term loan is taken, there


is an increase in working capital because of cash inflow. A short term loan,
however, does not increase the working capital because a short-term loan
increases the current assets (cash) and the current liability (short term
loan) by the same amount, leaving the size of working capital unchanged.

(iv) Sale Of Non-Current Assets: when a fixed asset or a long-term


investment or any other non-current asset is sold, there will be inflow

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represented by cash or short-term receivables.

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(b) Uses Of Funds: the following are the main uses of funds:
s.
(i) Payment Of Dividend: the transaction results in decrease in
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working capital owing to outflow of cash.
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(ii) Repayment Of Long-Term Liability:


The repayment of long-term loan involves cash outflow and
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hence it is used for working capital. The repayment of a current liability


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does not affect the amount of working capital because it entails an equal
reduction in current liabilities and current assets.
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(iii) Purchase Of Non-Current Assets:


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when a firm purchases fixed assets or other non-current assets, and


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if it pays cash or incurs a short-term debt, its working capital decreases.


Hence it is a use of funds.

3.1.3.3 Importance And Utility Of Funds Flow Analysis

Funds flow analysis provides an insight into the movement of funds and
helps in understanding the change in the structure of assets, liabilities and
owners equity. This analysis helps financial managers to find answers to
questions like:
(i) how far capital investment has been supported by long term
financing?

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(ii) how far short-term sources of financing have been used to


support capital investment?
(iii) how much funds have been generated from the operations of a
business?
(iv) to what extent the enterprise has relied on external sources of
financing?
(v) what major commitments of funds have been made during the
year?
(vi) where did profits go?
(vii) why were dividends not larger?
(viii) how was it possible to distribute dividends in excess of current
earnings or in the presence of a net loss during the current period?
(ix) why are the current assets down although the income is up?

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(x) has the liquidity position of the firm improved?

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(xi) what accounted for an increase in net current assets despite a
net loss for the period?
(xii) how was the increase in working capital financed? s.
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3.1.3.4 Preparation Of Funds Flow Statement
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Two statements are involved in funds flow analysis.


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(I) Statement Or Schedule Of Changes In Working Capital


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(II) Statement Of Funds Flow


(a) Statement Of Changes In Working Capital:
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This statement when prepared shows whether the working capital


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has increased or decreased during two balance sheet dates. But this does
not give the reasons for increase or decrease in working capital. This
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statement is prepared by comparing the current assets and the current


liabilities of two periods. It may be shown in the following form:

Schedule Of Changes In Working Capital (Proforma)


Items As on As on Change
Current Assets Increase Decrease
Cash Balances
Bank Balances
Marketable Securities
Stock In Trade
Pre-Paid Expenses

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Current Liabilities
Bank Overdraft
Outstanding Expenses
Accounts Payable
Provision For Tax
Dividend
Increase / Decrease In
Working Capital

Any increase in current assets will result in increase in working


capital and any decrease in current assets will result in decrease in working
capital. Any increase in current liability will result in decrease in working
capital and any decrease in current liability will result in increase in

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working capital.

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(b) Funds Flow Statement:
s.
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Funds flow statement is also called as statement of changes in
financial position or statement of sources and applications of funds or
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where got, where gone statement. The purpose of the funds flow statement
is to provide information about the enterprises investing and financing
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activities. The activities that the funds flow statement describes can be
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classified into two categories:


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(i) activities that generate funds, called sources, and


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(ii) activities that involve spending of funds, called uses.


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When the funds generated are more than funds used, we get an
increase in working capital and when funds generated are lesser than the
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funds used, we get decrease in working capital. The increase or decrease


in working capital disclosed by the schedule of changes in working capital
should tally with the increase or decrease disclosed by the funds flow
statement.

The funds flow statement may be prepared either in the form of a


statement or in `t shape form. When prepared in the form of statement it
would appear as follows:

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Funds Flow Statement


Sources Of Funds
Issues of shares x x x
Issue of debentures x x x
Long term borrowings x x x
Sale of fixed assets x x x
*operating profit
(funds from operations) x x x
Total sources x x x

Application Of Funds

Redemption of redeemable

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Preference shares x x x

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Redemption of debentures x x x
Payments for other long-term loans x x x
Purchase of fixed assets s. x x x
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* operation loss (funds lost from x x x
Operations) -------------------------
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Total uses x x x
--------------------------
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Net increase / decrease in working capital


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(total sources total uses)


When prepared in `t shape form, the funds flow statement would
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Appear as follows:
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Funds Flow Statement


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Sources Of Funds Application Of Funds


* Funds From Operation x x x *Funds Lost In Operations xx x
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Issue Of Shares x x x Redemption Of


Preference Shares xxx
Issue Of Debentures x x x Redemption Of Debentures xxx
Long-Term Borrowings x x x Payment Of Other Long-Term
Loans xxx
Sale Of Fixed Assets x x x Purchase Of Fixed Assets xxx
* Decrease In Working Payment Of Dividend, Tax,
Capital x x x Etc. xxx
Increase In Working Capital xxx
---------------------------------------------------------------------------------
*Only One Figure Will Be There.

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It may be seen from the proforma that in the funds flow statement
preparation, current assets and current liabilities are ignored. Attention is
given only to change in fixed assets and fixed liabilities.

In this connection an important point about provision for


taxation and proposed dividend is worth mentioning. These two may
either be treated as current liability or long-term liability. When treated
as current liabilities they will be taken to `schedule of changes in working
capital and thereafter no adjustment is required anywhere. If they are
treated as long-term liabilities there is no place for them in the schedule
of changes in working capital. The amount of tax provided and dividend
proposed during the current year will be added to net profits to find the
funds from operations. The amount of actual tax and dividend paid will be

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shown as application of funds in the funds flow statement. In this lesson,

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we have taken them as current liabilities.

3.1.3.5 Illustrations s.
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Illustration 1: the mechanism of preparation of funds flow statement is
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proposed to be explained with the help of annual reports for the years
2010-11 and 2011-12 pertaining to arasu limited.
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Arasu limited
Balance sheet as at 31st march
Rs.2000
2011-12 2010-11
Source of
funds
1. Share capital 1,40,00 1,40,00
2. Reserves and
surplus 2,77,84 2,30,62
--------- - --------
4,17,84 3,70,62
---------- ---------
Ii. Application
of funds

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1. Fixed assets 4,83,15 4,61,23
Less: dep.

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Provision

2. Investments
s.
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2,57,85 2,25,30 2,27,36 2,33,87


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--------- ---------
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20,25 20,30
3. Current Assets, Loans
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And Advances
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Inventories 1,52,83 1,92,54


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Debtors 51,41 64,29


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Cash And Bank 1,40,80 18,46


Loans & Advances 17,82 14,73
--------- ---------
3,62,86 2,90,02
--------- ---------
Less: Current Liabilities
& Provisions
Liabilities 89,81 76,70
Provisions 100,76 96,87
--------- ---------
1,90,57 1,73,57
--------- ---------

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182
Net Current Assets 1,72,29 1,16,45
--------- ---------
(Working Capital) 4,17,84 3,70,62

---------------------------------------------------------------------------------

Profit And Loss Account


For The Year Ended 31St March
Rs.`000
---------------------------------------------------------------------------------
2011-12 2010-11
---------------------------------------------------------------------------------

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Income

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Sales 4,94,19 5,36,63
Other Income 2,35,73 2,57,64
------------------------------------ s.
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7,29,92 7,94,27
------------------------------------
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Expenditure
Opening Stock 20,45 25,59
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Raw Materials Consumed 87,35 95,67


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Packing Materials Consumed 2,87,78 3,29,04


Excise Duty 23,90 27,26
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Expenses 1,65,38 1,29,94


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Directors Fees 11 10
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Interest 94 5,69
Depreciation 30,49 39,98
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-------------------------------------
6,16,40 6,53,27
Less: Closing Stock 19,06 20,45
------------------------------------
5,97,34 6,32,82
------------------------------------
Profit Before Taxation 1,32,58 1,61,45
Provision For Income-Tax (64,36) (82,40)
------------------------------------
68,22 79,05
Profit Brought Forward From

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Previous year 12 1
------------------------------------
Balance 68,34 79,06
183
Provision for taxation
Relating to earlier year ---- (46,27)
Miscellaneous expenditure
Written off ---- (15,67)
---------------------------------
Balance available for
Appropriation 68,34 17,12
---------------------------------
Appropriations

m
General reserve 47,25 3,00

co
Proposed reserve for appropriation 21,00 14,00
---------------------------------
68,25 17,00 s.
bu
---------------------------------
Balance carried over to next year 9 12
la

---------------------------------------------------------------------------------
----------------
yl

For the above financial statements, funds flow statement is prepared as


lls

Follows with necessary workings:


.a

I. Calculation Of Funds From Operations For The Year 2011-12


w

(Rs.`000)
w

Balance of profit carried over to next year 9


Add: provision for depreciation 30,49
w

Transfer to general reserves 47,25


-------
77,83
Less: balance of profit brought forward from previous year 12
-------
Funds from operations 77,71
-------
Note: provision for income-tax and proposed dividend are taken as current
liabilities. Hence they are not added here. They will be taken to schedule of
Changes in working capital.

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Ii. Fixed Assets: from a perusal of schedule relating to `fixed assets in the
annual report, it is ascertained that there was a sale of fixed assets amounting
to rs.16,62,000 and purchase of fixed assets to the tune of rs.38,54,000.
These will be shown as source and application of funds respectively. (in
examination problems information about, sale and purchase of assets can
be ascertained by preparing respective asset accounts).

Iii. Investments:

A similar perusal of schedule relating to `investments gives information


that there was a redemption of investment amounting to rs.5,000 which is
a source of fund.

m
Now the schedule of changes in working capital and funds flow

co
Statement are prepared.

s.
Arasu Limited
bu
Schedule Of Changes In Working Capital 2011-12
(Rs.`000)
la

2010-11 2011-12 Increase Decrease


Current Assets
yl

Inventories 1,92,54 1,52,83 --- 39,71


lls

Debtors 64,29 51,41 --- 12,88


Cash and
.a

Bank 18,46 1,40,80 1,22,34 ---


w

Loans and
w

Advances 14,73 17,82 3,09 ---



w

(A) Total Of -------------------------


Current Assets 2,90,02 3,62,86
-------------------------
Current Liabilities
Creditors 75,43 88,81 --- 13,38
Unpaid
Dividend 1,27 1,00 27 ---
Provision for
Tax 82,87 79,76 3,11 ---
Proposed
Dividend 14,00 21,00 --- 7,00

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-------------------------
(b) Total Of Current 1,73,57 1,90,57
liabilities -------------------------
Working
Capital (a)-(b) 1,16,45 1,72,29 --- ---
Increase in working
Capital 55,84 --- --- 55,84
--------------------------------------------------------------------------
1,72,29 1,72,29 1,28,81 1,28,81
--------------------------------------------------------------------------

Arasu Limited
Funds Flow Statement 2011-12

m
Sources Applications

co
Rs. Rs.
Funds from operations 77,71 purchase of fixed assets 38,54
Sale of fixed assets 16,62 s.
increase in working
bu
capital 55,84
Redemption of investment 5
la

------- -------
94,38 94,38
yl

---------------------------------------------------------------------------------
lls

It may be seen from the above statement that sources amount to


rs.94,38,000 and applications amount to rs.38,54,000, thereby resulting
.a

in an increase in working capital amounting to rs.55,84,000. This figure


w

tallies with the increase in working capital as shown by the schedule of


w

changes in working capital.


w

Illustration 2:

The balance sheet of mathi limited for two years was as follows:
Liabilities Assets
---------------------------------------------------------------------------------
2010 2011 2010 2011
---------------------------------------------------------------------------------
Share Capital 40,000 60,000 Land & 27,700 56,600
Buildings
Share Premium 4,000 6,000 Plant & 17,800 25,650
Machinery

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General Reserve 3,000 4,500 Furniture 1,200 750


Profit & Loss A/C 9,750 10,400 Stock 11,050 13,000
5% Debentures --- 13,000 Debtors 18,250 19,550
Creditors 16,750 18,200 Bank 2,400 2,000
Provision For 4,900 5,450
Taxation --------------------- -----------------------------
78,400 1,17,550 78,400 1,17,550
---------------------------------------------------------------------------------

Additional Information

Depreciation written off during the year was:


Plant and machinery rs.6,400

m
Furniture rs. 200

co
Prepare: a schedule of changes in working capital and a statement of
sources and application of funds.
s.
bu
Schedule Of Changes In Working Capital
Working Capital
la

2010 2011 Increase Decrease


Rs. Rs. Rs. Rs.
yl

---------------------------------------------------------------------------------
lls

Current Assets
.a

Stock 11,050 13,000 1,950


w

Debtors 18,250 19,550 1,300


w

Bank 2,400 2,000 400


---------------------------------------------------------
w

(a) 31,700 34,550


---------------------------------------------------------
Current Liabilities
Creditors 16,750 18,200 1,450
Provision for
Taxation 4,900 5,450 550
------------------------
(b) 21,650 23,650
------------------------
Working capital
(a) (b) 10,050 10,900

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Increase in working
Capital 850 850
---------------------------------------------------------------------------------
10,900 10,900 3,250 3,250
---------------------------------------------------------------------------------
Calculation Of Funds From Operations

Profit And Loss A/C As On 31-12-2011 10,400


Add: Transfer To Reserve 1,500
Depreciation Plant & Machinery
6,400 Furniture 200
18,500
Less: P&L A/C As On 1-1-2011 9,750

m
---------

co
Funds From Operations 8,750
---------
Land & Building A/C s.
bu
To Balance B/D 27,700 By Balance C/D 56,600
To Bank Purchase 28,900
la

(Balancing Figure) -------- --------


56,600 56,600
yl

-------- --------
lls

Plant & Machinery A/C


To Balance B/D 17,800 By Depreciation 6,400
.a

To Bank Purchase 14,250 By Balance C/D 25,650


w

(Balancing Figure) -------- --------


w

32,050 32,050
-------- --------
w

---------------------------------------------------------------------------------
Furniture A/C
To Balance B/D 1,200 By Depreciation 200
By Bank Sale 250
(Balancing Figure)
By Balance C/D 750
------- -------
1,200 1,200
---------------------------------------------------------------------------------

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Statement of Sources And Application of Funds


Sources Rs. Applications Rs.
Funds From Operations 8,750 Purchase Of Land & 28,900
Share Capital 20,000 Buildings
Share Premium 2,000 Purchase Of Plant & 14,250
Debentures 13,000 Increase In Working 850
Sale Of Furniture 250 Capital
--------- --------
44,000 44,000
-------- --------
---------------------------------------------------------------------------------

3.1.3.6 Meaning of Concepts of Cash, Cash Flow And Cash Flow

m
Analysis

co
While explaining the concept of `fund it was mentioned that in a
s.
narrower sense the term `fund is also used to denote cash. The term `cash
bu
in the context of cash flow analysis stands for cash and bank balances. Cash
flow refers to the actual movement of cash in and out of an organisation.
la

When cash flows into the organisation it is called cash inflow or positive
cash flow. In the same way when cash flows out of the organisation, it
yl

is called cash outflow or negative cash flows. Cash flow analysis is an


lls

analysis based on the movement of cash and bank balances. Under cash
flow analysis, all movements of cash would be considered.
.a
w

3.1.3.7 Cash Flow Statement


w

A cash flow statement is a statement depicting changes in cash


w

position from one period to another i.e. The result of cash flow analysis
is given in the cash flow statement. For example if the cash balance of
a concern as per its balance sheet as on 31st march 2004 is rs.90,000
and the cash balance as per its balance sheet as on 31st march 2005 is
rs.1,20,000, there has been an inflow of cash of rs.30,000 in the year 2004-
05 as compared to the year 2003-04. The cash flow statement explains the
reasons for such inflows or outflows of cash as the case may be.
Normally the following are principal sources of inflows of cash:
Issue Of Shares And Debentures For Cash
Sale Of Fixed Assets And Investments For Cash
Borrowings From Banks And Other Financial Institution

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Cash From Operations


Outflows of cash generally include:
Redemption Of Shares And Debentures By Cash
Purchase Of Fixed Assets And Investments By Cash
Repayment Of Loans
Cash Lost In Operations
The following is the format of a cash flow statement:

Cash Flow Statement For The Year Ending Say 31st March 2012
Balance as on 1-4-2011 balance as on 1-4-2011
Cash in hand x x x bank overdraft (if any) xx x
Cash at bank xxx
Add: cash inflows: cash outflows:

m
Here the items mentioned here the items mentioned

co
As sources of cash inflows as outflows of cash above
Above will be recorded will be recorded
Balance as on 31-3-2012 s.
balance as on 31-3-2012
bu
Bank overdraft (if any) x x x cash in hand xx x
Cash at bank xxx
la

------ ------
x x x x x x
yl

------ ------
lls

---------------------------------------------------------------------------------
The accounting standard 3 issued by the institute of chartered accountants
.a

of india requires the companies to prepare cash flow statement and present
w

them as part of their annual reports.


w

3.1.3.8 Calculation of Cash From Operations


w

The important step in the preparation of cash flow statement is the


calculation of cash from operations. It is calculated as follows:
The first step in the calculation of cash from operations is the calculation
of funds from operations (which is already explained in the lesson on funds
flow analysis). To the funds from operations the decrease in current assets
and increase in current liabilities will be added (except cash, bank and
bank o.d.). From the added total, increase in current assets and decrease in
current liabilities will be deducted (except cash, bank and bank o.d.). The
resultant figure is cash from operations (refer illustration 3).

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Proforma Of Cash From Operations Statement


Funds from operations or funds lost from operations xxxx
Add: Decrease in current assets xxxx
Increase in current liabilities xxxx
--------
x x x x
--------
Less: Inecrease in current assets xxx
Decrease in current liabilities xxx
x x x x

Cash from operations or cash lost from operations

m
As in the case of fund flow analysis here also we assume provision for

co
taxation and proposed dividend as current liabilities.

3.1.3.9 Utility of Cash Flow Analysiss.


bu
Cash flow analysis yields the following advantages:
la

It is very helpful in understanding the cash position of the firm.


This would enable the management to plan and coordinate the
yl

financial operations properly.


lls

Since it provides information about cash which would be available


from operations the management would be in a position to plan
.a

repayment of loans, replacement of assets, etc.


w

It throws light on the factors contributing to the reduction of cash


w

balance inspite of increase in income and vice versa.


A comparison of the cash flow statement with the cash budget for
w

the same period helps in comparing and controlling cash inflows


and cash outflows.

However cash flow analysis is not without limitations. The cash


balance as disclosed by the cash flow statement may not represent the
real liquid position of the business since it can be easily influenced by
postponing purchases and other payments. Further cash flow statement
cannot replace the income statement or funds flow statement. Each of
them has a separate function to perform.

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3.1.3.10 Cash Flow Analysis Vs. Funds Flow Analysis

A cash flow statement is concerned only with the changes in cash


position while funds flow analysis is concerned with changes in
working capital position between two balance sheet dates.
Cash flow analysis is a tool of short-term financial analysis while
the funds flow analysis is comparatively a long-term one.
Cash is part of working capital and therefore an improvement in
cash position results in improvement in the funds position but
not vice versa. In other words inflow of cash results in inflow
of funds but inflow of funds may not necessarily result in inflow
of cash.
In funds flow analysis, the changes in various current assets

m
and current liabilities are shown in a separate statement called

co
schedule of changes in working capital in order to ascertain the
net increase or decrease in working capital. But in cash flow
s.
analysis, such changes are adjusted to funds from operations in
bu
order to ascertain cash from operations.
la

3.1.3.11 illustrations
yl

Illustration 3:
lls

From the following balances calculate cash from operations:


December 31
.a

2010 2011
w

Profit and loss a/c balance 75,000 1,55,000


w

Debtors 45,000 42,000


Creditors 20,000 26,000
w

Bills receivable 12,000 15,000


Cash in hand 2,500 3,000
Prepaid expenses 1,600 1,400
Bills payable 18,000 16,000
Cash at bank 8,000 10,000
Outstanding expenses 1,200 1,600
Income received in advance 250 300
Outstanding income 800 900
Additional Information:
(i) depreciation written off during the year rs.10,000
(ii) transfer to general reserve rs.10,000

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Calculation Of Funds From Operations


Rs.
Profit & Loss A/C As On 31St December 2011 1,55,000
Add: Depreciation 10,000
Transfer To General Reserve 10,000
-----------
1,75,000
Less: P & L A/C As On 1St January 2011 75,000
-----------
Funds From Operations 1,00,000
-----------
Calculation Of Cash From Operations
Funds from operations 1,00,000

m
Add: Decrease In Current Assets

co
Decrease in debtors 3,000
Decrease in prepaid expenses 200
s.
Increase In Current Liabilities
bu
Increase in creditors 6,000
Increase in outstanding expenses 400
la

Increase in income received in advance 50


---------
yl

1,09,650
lls

Less: Increase In Current Assets


Increase in bills receivables 3,000
.a

Increase in outstanding income 100


w

Decrease In Current Liabilities


w

Decrease in bills payable 2,000


5,100
w

-----------
Cash from operations 1.04,550
-----------
Note: decrease in current assets means current assets are converted into
cash and increase in current liabilities results in further generation of cash.
Hence they are added. Increase in current assets and decrease in current
liabilities result in outflow of cash. Hence they are deducted.

Illustration 4: balance sheets of somy thomas as on 1-1-2011 and 31-12-


2011 were as follows:

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Liabilities 2010 2011 Assets 2010 2011


Rs. Rs. Rs. Rs.

Credits 40,000 44,000 Cash 10,000 7,000


Bills Payable 25,000 --- Debtors 30,000 50,000
Loans From
Bank 40,000 50,000 Stock 35,000 25,000
Capital 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Building 35,000 60,000
-------------------------------------------------------------------------
2,30,000 2,47,000 2,30,000 2,47,000
-------------------------------------------------------------------------

m
---------------------------------------------------------------------------------

co
During the year, a machine costing rs.10,000 (accumulated
s.
depreciation rs.3,000) was sold for rs.5,000. The provision for depreciation
bu
against machinery as on 1-1-2011 was rs.25,000 and on 31-12-2011 it was
rs.40,000. Net profit for the year 2011 amounted to rs.45,000. Prepare cash
la

flow statement.
yl

Calculation of Cash From Operations


lls

Rs.
Net Profit For The Year 2011 45,000
.a

Add: Addition To Provision For Depreciation 18,000


w

Loss Of Sale Of Machinery 2,000


w

---------
Funds From Operations 65,000
w

Add: Decrease In Stock 10,000


Increase In Creditors 4,000
--------
79,000
Less: Increase In Debtors 20,000
Decrease In Bills Payable 25,000
-------- 45,000
--------
Cash From Operations 34,000

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Capital A/C
To Drawings 17,000 By Balance B/D 1,25,000
(Balancing Figure)
To Balance C/D 1,53,000 By Net Profit For
The Year 45,000

1,70,000 1,70,000

Machinery A/C
To Balance B/D 1,05,000 By Bank Sale 5,000
(80000 + 25000) By Provision For Dep. 3,000
By P&L A/C Loss 2,000

m
By Balance C/D 95,000

co
(55000 + 40000)
1,05,000 1,05,000
s.
bu
Provision For Depreciation A/C
la

To Machinery A/C 3,000 By Balance B/D 25,000


yl

(Dep. On Machinery
lls

Sold) By P&L A/C


To Balance C/D 40,000 Dep. For The Current
.a

Year 18,000
w

43,000 43,000
w

Cash Flow Statement


w

Cash As On 1-1-2011 10,000


Add: Inflows Cash Outflows:
Cash From
Operations 34,000 Drawings 17,000
Loan From Bank 10,000 Purchase Of Land 10,000
Sale Of Machinery 5,000 Purchase Of Building 25,000
Cash As On
31-12-2011 7,000
59,000 59,000

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3.1.3.12 Summary

A funds flow statement officially called as statement of changes in


financial position, provides information about an enterprises investing
and financing activities during the accounting period. Though there
are many concepts of funds, the working capital concept of funds has
been used in this lesson. Flow of funds results only when there is a cross
transaction i.e. Only when a transaction involves a fixed asset or liability
and a current asset or liability. The main sources of funds are: funds from
operations, issue of shares and debentures and sale of non-current assets.
The main uses of funds are repayment of long-term liabilities including
redemption of preference shares and debentures, purchase of non-current
assets and payment of dividends. Funds flow statement helps the financial

m
analyst in having a more detailed analysis and understanding of changes

co
in the distribution of sources between two balance sheet dates. In addition
to funds flow statement concerns are also preparing cash flow statement
s.
which is the outcome of cash flow analysis. Cash flow analysis is based on
bu
the movement of cash and bank balances and the cash flow statement is a
statement depicting changes in cash position from one period to another
la

period.
yl

3.1.3.13 Key Words


lls

Working Capital: working capital is that part of capital used for the
.a

purposes of day-to-day operations of a business.


w
w

Fund: fund refers to the long term capital used for financing current assets.
It can be ascertained by finding the difference between current assets and
w

current liabilities.

Flow of funds: flow refers to transactions which change the size of fund in
an organisation. The flow transactions are divided into uses and sources.
While the former refers to those transactions which reduce the funds, the
latter increases the size of fund.

Cash: cash refers to cash and bank balances.

Cash Flow: cash flow refers to the actual movement of cash in and out of
an organisation.

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3.1.3.14 Self Assessment Questions


1. What do you mean by working capital concept of funds?
2. Explain the significance of funds flow analysis and cash flow
analysis.
3. Distinguish between schedule of changes in working capital and
funds flow statement.
4. Distinguish between cash flow analysis and funds flow analysis.
5. Shyam and company has the following information for the year
ending
31st march 2012:sales rs.5,000, depreciation rs. 450, other operating
expenses rs.4,100
You are required to:
Estimate The Amount Of Funds Generated During The Year.

m
If The Amount Of Depreciation Increases To Rs.9,000 What

co
Would Be Its Effect On Funds Generated During The Year.
Under What Circumstances Can The Funds From Operation Be
Zero? s.
bu
6. From the following balance sheets of damodar ltd. As on 31st december
2010 and 2011 you are required to prepare:
la

A Schedule Of Changes In Working Capital


A Funds Flow Statement
yl
lls

Assets 2010 2011


Goodwill 12,000 12,000
.a

Building 40,000 36,000


w

Plant 37,000 36,000


w

Investments 10,000 11,000


Stock 30,000 23,400
w

Bills receivable 2,000 3,200


Debtors 18,000 19,000
Cash at bank 6,600 15,200

1,55,600 1,55,800

Liabilities 2010 2011


Share capital 1,00,000 1,00,000
General reserve 14,000 18,000
Creditors 8,000 5,400
Bills payable 1,200 800

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Provision for taxation 16,000 18,000


Provision for doubtful debts 400 600
Profit & loss a/c 16,000 13,000
1,55,600 1,55,800

Additional information:
Depreciation charged on plant was rs.4,000 And on building
Rs.4,000.
Provision for taxation rs.19,000.
Interim dividend of rs.8,000 Was paid during the year 2011.
7. The financial position of subhulakshmi ltd. On 1-1-2011 and 31-122011
Was as follows:

m
Liabilities 2010 2011 Assets 2010 2011

co
Rs. Rs. Rs. Rs.
Current Liabilities 72,000 82,000 Cash 8,000 7,200
Loan From Rosary 40,000 Debtors s. 70,000 76,800
bu
Ltd. Stock 50,000 44,000
Loan From Gayatri 60,000 50,000 Land 40,000 60,000
la

Ltd. Buildings 1,00,00 1,10,000


Capital & Reserves 2,96,000 2,98,000 Machinery 1,60,00 1,72,000
yl
lls

4,28,000 4,70,000 4,28,000 4,70,000


.a
w
w

During the year rs.52,000 were paid as dividends. The provision for
Depreciation against machinery as on 1-1-2011 was rs.54,000 and on 31-
w

12-2011 was rs.72,000. Prepare a cash flow statement.

3.1.3.15 Key To Self Assessment Questions (For Problems Only)

Q.No.5: (I) Rs.900; (Ii) Rs.900; (Iii) When Other Operating Expenses
Are Increased To Rs.5,000 Or Sales Decreased To Rs.4,100 Without Any
Decrease In Other Operating Expenses.
Q.No.6: Increase In Working Capital Rs.5,000; Funds From Operations
Rs.17,000.
Q.No.7: Funds From Operations Rs.72,000; Cash From Operations
Rs.81,200.

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3.1.3.16 Case Analysis

Given below are the balance sheets of bharathy ltd. For a period of three
years as at 31st march each.
Rs. In lakhs
2010 2011 2012
Liabilities
Share capital in equity shares of rs.10
Each 30 35 35
General reserve 10 15 18
Surplus 5 8 9
13% debentures 10 5 10
Bank credit 5 10 15

m
Trade creditors 10 12 15

co
Income tax provision 8 11 14
Proposed dividend 6 10.5 14
s.
bu
84 106.5 130
la

Assets
Plant and machinery 45 55 70
yl

Investments 10 15 20
lls

Stock 12 15 15
Debtors 14 15 12
.a

Cash and bank 3 6.5 13


w
w

84 106.5 130
w

Other Details:
Depreciation provided in the books:
2009-10: Rs.6 Lakhs; 2010-11: rs.8 Lakhs; 2011-12: rs.10 Lakhs
A part of the debentures was converted into equity at par in
september 2010.
There was no sale of fixed assets during the period.

As you are the management accountant of the concern, the management


seeks your advice on the liquidity position of the company. Analyse the
case and advice the management using funds flow analysis.

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Hint:
Calculate funds from operations.
Prepare schedule of changes in working capital.
Prepare funds flow statement.
Calculate current ratio and liquidity ratio.
Based on the above workings suitable advice may be given to the
management.

3.1.3.17 Books For Further Reading

1. James Jimbalvo: Management Accounting, John Wiley & Sons.


2. Khan & Jain: Management Accounting, Tata Mcgraw Hill Publishing
Co., New Delhi.

m
3. J.Made Gowda: Management Accounting, Himalaya Publishing House,

co
Delhi.
4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons, New
Delhi. s.
bu
5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting For Management,
S.Chand & Co., New Delhi.
la
yl

*****
lls
.a
w
w
w

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m
co
s.
bu
la
yl
lls
.a
w
w
w

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Unit IV: Management Accounting

Lesson 4.1: Marginal Costing

4.1.1 Introduction

Marginal costing is a technique of costing. This technique of


costing uses the concept `marginal cost. Marginal cost is the change in
the total cost of production as a result of change in the production by one
unit. Thus marginal cost is nothing but variable cost. In marginal costing
technique only variable costs are considered while calculating the cost
of the product, while fixed costs are charged against the revenue of the

m
period. The revenue arising from the excess of sales over variable costs

co
is known as `contribution. Using contribution as a vital tool, marginal
costing helps to a great extent in the managerial decision making process.
s.
This unit deals with the various aspects of marginal costing.
bu
4.1.2 Learning Objectives
la

After reading this lesson, the reader should be able to:


yl

know the meaning of marginal cost.


lls

understand the various elements of marginal costing technique.


appreciate the importance of marginal costing as a decision
.a

making tool.
w

realise the advantages and disadvantages of marginal costing.


w

apply marginal costing technique under appropriate situations.


w

4.1.3 Contents

4.1.3.1 Various Elements Of Marginal Costing


4.1.3.2 Benefits Of Marginal Costing
4.1.3.3 Application Of Marginal Costing
4.1.3.4 Limitations Of Marginal Costing
4.1.3.5 Additional Illustrations
4.1.3.6 Summary
4.1.3.7 Key Words
4.1.3.8 Self Assessment Questions
4.1.3.9 Key To Self Assessment Questions

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4.1.3.10 Case Analysis


4.1.3.11 Books For Further Reading

4.1.3.1 Various Elements Of Marginal Costing

According to the institute of cost and management accountants


(icma), london, marginal cost is `the amount at any given volume of output
by which aggregate costs are changed if the volume of output is increased
or decreased by one unit. Thus marginal cost is the added cost of an extra
unit of output.
Mc = Direct Material + Direct Labour + Other Variable Costs
= Total Cost Fixed Cost.

m
Contribution

co
The difference between selling price and variable cost (or marginal
s.
cost) is known as `contribution or `gross margin. It may be considered as
bu
some sort of fund from out of which all fixed costs are met. The difference
between contribution and fixed cost represents either profit or loss, as the
la

case may be. Contribution is calculated thus:


Contribution = Selling Price Variable Cost
yl

= Fixed Cost + Profit Or Loss


lls

It is clear from the above equation that profit arises only when contribution
exceeds fixed costs. In other terms, the point of no profit no loss will be at
.a

a level where contribution is equal to fixed costs.


w
w

Marginal cost equation


w

The algebraic expression of contribution is known as marginal cost


equation. It can be expressed thus:

S V = F+P
S V = C
C = F + P And In Case Of Loss
C = FL
Where: S = Sales
V = Variable Cost
C = Contribution
F = Fixed Cost

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P = Profit
L = Loss

Profit Volume Ratio (P/V Ratio)

The profitability of business operations can be found out by


calculating the p/v ratio. It shows the relationship between contribution and
sales and is usually expressed in percentage. It is also known as `marginal-
income ratio, `contribution-sales ratio or `variable-profit ratio. P/v ratio
thus is the ratio of contribution to sales, and is calculated thus:
Contribution
P/V Ratio = ----------------- X 100
Sales

m
C SV F+P

co
= --- or --------- or --------
S S S
Variable Costs s.
bu
= 1 - ---------------------
Sales
la

The ratio can also be shown by comparing the change in contribution to


change in sales, or change in profit to change in sales. Any increase in
yl

contribution, obviously, would mean increase in profit, as fixed expenses


lls

are assumed to be constant at all levels of production.


.a

Change In Contribution
w

P/V Ratio = -------------------------------


w

Change In Sales
w

Change In Profit
= ------------------------
Change In Sales

The importance of p/v ratio lies in its use for evaluating the
profitability of alternative products, proposals or schemes. A higher ratio
shows greater profitability. Management should, therefore, try to increase
p/v ratio by widening the gap between the selling price and the variable
costs. This can be achieved by increasing sale price, reducing variable costs
or switching over to more profitable products.

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Break-Even or Cost-Volume-Profit Analysis

Break-even analysis is a specific method of presenting and studying


the inner relationship between costs, volume and profits. (hence, the name
c-v-p analysis). It is an important tool of financial analysis whereby the
impact on profit of the changes in volume, price, costs and mix can be
found out with a certain amount of accuracy. A business is said to break
even when its total sales are equal to its total costs. It is a point of no profit
or no loss. At this point contribution is equal to fixed costs. Break-even
point, can be calculated thus:

Fixed Cost
B.E.P. (In Units) = --------------------------

m
Contribution Per Unit

co
Fixed Cost
s.
= ---------------------------------------------
bu
Selling Price/Unit Marginal Cost/Unit
la

Fixed Cost
yl

B.E.P. (Sales) = --------------------------- X Selling Price/Unit


lls

Contribution Per Unit


Fixed Cost
.a

= ------------------------- X Total Sales


w

Total Contribution
w

FXS
or = ------------
w

SV
Fixed Cost
or = -----------------------------------
Variable Cost Per Unit
1 - ----------------------------------
Selling Price Per Unit

Fixed Cost
or = ------------------
P/V Ratio

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At break-even point the desired profit is zero. Where the volume of output
or sales is to be calculated so as to earn a desired amount of profit, the
amount of desired profits has to be added to the fixed cost given in the
above formula.
Fixed Cost + Desired Profit
Units To Earn A Desired Profit = -------------------------------------
Contribution Per Unit
Fixed Cost + Desired Profit
Sales To Earn A Desired Profit = ------------------------------------
P/V Ratio
Cash Break-Even Point

It is the level of output or sales where the cash inflow will be

m
equivalent to cash needed to meet immediate cash liabilities. To this end,

co
fixed costs have to be divided into two parts (i) fixed cost which do not
need immediate cash outlay (depreciation etc.) And (ii) fixed cost which
s.
need immediate cash outlay (rent etc.). Cash break-even point can be
bu
calculated thus:
Cash Fixed Costs
la

Cash Break-Even Point (Of Output) = -----------------------------------


Cash Contribution Per Unit
yl
lls

Composite Break-Even Point


.a

Where a firm is dealing with several products, a composite


w

breakeven point can be calculated using the following formula:


w

Cash Fixed Costs


Composite Break-Even Point (Sales) = ----------------------------------
w

Composite P/V Ratio

Total Fixed Costs X Total Sales


or = --------------------------------------
Total Contribution

Total Contribution
or = ---------------------------- X 100
Total Sales

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Margin of Safety

Total sales minus the sales at break-even point is known as the margin of
safety. Lower break-even point means a higher margin of safety. Margin of
safety can also be expressed as a percentage of total sales. The formula is:
Margin Of Safety = Total Sales Sales At B.E.P.
Profit
or = ------------------
P/V Ratio

Margin Of Safety
Margin Of Safety = ----------------------- X 100
(As A Percentage) Total Sales

m
co
Higher margin of safety shows that the business is sound and when
sales substantially come down, (but not below break even sales) profit
s.
might be earned by the business. Lower margin of safety, as pointed out
bu
earlier, means that when sales come down slightly profit position might be
affected adversely. Thus, margin of safety can be used to test the soundness
la

of a business. In order to improve the margin of safety a business can


increase selling prices (without affecting demand, of course) reducing
yl

fixed or variable costs and replacing unprofitable products with profitable


lls

one.
.a

Illustration 1: beta manufacturers ltd. Has supplied you the following


w

information in respect of one of its products:


w

Total Fixed Costs 18,000


w

Total Variable Costs 30,000


Total Sales 60,000
Units Sold 20,000

Find out (a) contribution per unit, (b) break-even point, (c) margin of
safety, (d) profit, and (e) volume of sales to earn a profit of rs.24,000.

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Solution:
60,000
Selling Price Per Unit = -------- = Rs.3
20,000

30,000
Variable Cost Per Unit = -------- = Rs.1.50
20,000

(A) Contribution Per Unit = Selling Price Per Unit Variable Cost Per
Unit
= Rs.3 Rs.1.50
= Rs.1.50

m
Total Fixed Cost

co
(B) Break-Even Point = -------------------------------
Contribution Per Unit
s.
bu
Rs.18,000
= -------------
la

Rs.1.50
yl

= 12,000 Units
lls

(C) Margin Of Safety = Units Sold Break-Even Point


.a

= 20,000 12,000
w

= 8,000 Units (Or) Rs.24,000


w

(D) Profit = (Units Sold X Contribution Per Unit) -


w

Fixed Cost
= (20,000 X Rs.1.50) - Rs.18,000
= Rs.12,000

(E) Volume Of Sales To Earn A Profit Of Rs.24,000


Fixed Cost + Desired Profit
= --------------------------------------
Contribution Per Unit
18,000 + 24,000
= ---------------------- = 28,000 units
1.50

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Illustration 2: Calculate `Margin Of Safety from the following data:


---------------------------------------------------------------------------------
Particulars Mary & Co. Geetha& Co.
---------------------------------------------------------------------------------

Sales 1,00,000 1,00,000


Cost 80,000 80,000
Fixed Mary & Co. 30,000
Geetha & Co. 50,000

Variable Mary & Co. 50,000


Geetha & Co. 30,000

m
---------- ---------- ----------

co
Profit 20,000 20,000
---------- ---------- ----------
s.
bu
Solution:
la

Particulars Mary& Co. Geetha& Co.


yl
lls

Actual Sales 1,00,000 1,00,000


Less: Sales At Break-Even Point 60,000 71,429
.a

Marginal Of Safety 40,000 28,571


w
w

Fixed Cost
Break-Even Sales = ----------------
w

P/V Ratio
Sales Variable Cost
P/V Ratio = ----------------------------
Sales
Therefore;
P/V Ratio 1,00,000 1,00,000
- 50,000 - 30,000
50,000 70,000

50% 70%

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30,000 50,000
Break-Even Sales = ---------- --------
50% 70%
Rs.60,000 Rs.71,429

Illustration 3:

From the following particulars, find out the selling price per unit
if b.E.P. Is to be brought down to 9,000 units.
Variable Cost Per Unit Rs.75
Fixed Expenses Rs.2,70,000
Selling Price Per Unit Rs.100

m
Solution:

co
Let us assume that the contribution per unit at B.E.P. Sales of 9,000
is X. s.
bu
Fixed Cost
B.E.P. = ------------------------------
la

Contribution Per Unit


Contribution per unit is not known. Therefore,
yl

2,70,000
lls

9,000 Units = -------------


X
.a

9,000 X = 2,70,000
w

X = 30
w

Contribution Is Rs.30 Per Unit, In Place Of Rs.25. So, The Selling Price
Should Be Rs.105, I.E. Rs.75 + Rs.30.
w

4.1.3.2 Benefits Of Marginal Costing

The technique of marginal costing is of immense use to the


management in taking various decisions, as explained below:

1. How Much To Produce?

Marginal costing helps in finding out the level of output which is


most profitable for running a concern. This, in turn, helps in utilising plant
capacity in full, and realise maximum profits. By determining the most

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profitable relationships between cost, price and volume, marginal costing


helps a business determine most competitive prices for its products.

2. What To Produce?

By applying marginal costing techniques, the most suitable


production line could be determined. The profitability of various products
can be compared and those products which languish behind and which do
not seem to be feasible (in view of their inability to recover marginal costs),
may be eliminated from the production line by using marginal costing. It,
thus, helps in selecting an optimum mix of products, keeping the capacity
and resource constraints in mind. It will also serve as a guide in arriving at
the price for new products.

m
co
3. Whether To Produce Or Procure?

s.
The marginal cost of producing an article inside the factory serves
bu
as a useful guide while arriving at make or buy decisions. The costs of
manufacturing can be compared with the costs of buying outside and a
la

suitable decision can be arrived at easily.


yl

4. How To Produce?
lls

In case a particular product can be produced by two or more


.a

methods, ascertaining the marginal cost of producing the product by each


w

method will help in deciding as to which method should be allowed. The


w

same is true in case of decisions to use machine power in place of manual


labour.
w

5. When To Produce?

In periods of trade depression, marginal costing helps in deciding


whether production in the plants should be suspended temporarily or
continued in spite of low demand for the firms products.

6. At What Cost To Produce?

Marginal costing helps in determining the no profit- no-loss point.


The efficiency and economy of various products, plants, departments can

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also be determined. This helps in profit planning as well as cost control.

4.1.3.3 Application Of Marginal Costing

Marginal costing technique helps management in several ways.


These are discussed below:

1. Profit Planning

There are four important ways of improving the profit performance


of a business: (i) increasing the volume, (ii) increasing the selling price, (iii)
Decreasing variable cost, and (iv) decreasing fixed costs. Profit planning
is the planning of future operations so as to attain maximum profit. The

m
contribution ratio shows the relative profitability of various sectors of

co
business whenever there is a change in the selling price, variable cost etc.

Illustration 4: s.
bu
Two businesses, p ltd. And q ltd. Sell the same type of product in
la

the same type of market. Their budgeted profit and loss accounts for the
coming year are as under:
yl

P Ltd. Q Ltd.
lls

Sales 1,50,000 1,50,000


Less: Variable Costs 1,20,000 1,00,000
.a

Fixed Costs 15,000 1,35,000 35,000 1,35,000


w

Budget Net Profit 15,000 15,000


w

You are required to:


Calculate the break-even point for each business
Calculate the sales volume at which each business will earn
rs.5,000 Profit.
State which business is likely to earn greater profit in conditions
of:
1. Heavy demand for the product
2. Low demand for the product, and, briefly give your argument
also.

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Solution:

(I) For Calculating The Break-Even Points, P/V Ratio Of P Ltd. And Q
Ltd.,
Should Be Calculated:
P/V Ratio = Contribution / Sales
Fixed Expenses + Profit
= ------------------------------
Sales
15,000 + 15,000 1
P/V Ratio Of P = ------------------------- = --- = 20%
1,50,000 5

m
35,000 + 15,000 1

co
P/V Ratio Of Q = ------------------------ = --- = 3 1/3%
1,50,000 3
s.
bu
Fixed Expenses
Break-Even Point = -------------------------
la

P/V Ratio
yl

15,000
lls

P Ltd. = ----------- = Rs.75,000


1/5
.a
w

35,000
w

Q Ltd. = ------------ = Rs.1,05,000


1/3
w

(II) Sales Volume To Earn A Desired Profit (Rs.5000):

Fixed Expenses + Desired Profit


Formula = ----------------------------------------
P/V Ratio

15,000 + 5,000
P Ltd. = ------------------- = Rs.1,00,000
1/5

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35,000 + 5,000
Q Ltd. = ------------------- = Rs.1,20,000
1/3
In conditions of heavy demand, a concern with larger p/v ratio
can earn greater profits because of greater contribution. Thus, q
ltd. Is likely to earn greater profit.
In conditions of low demand, a concern with lower break-even
point is likely to earn more profits because it will start earning
profits at a lower level of sales. In this case, p ltd. Will start earning
profits when its sales reach a level of rs.75,000, Whereas q ltd. Will
start earning profits when its sales reach rs.1,05,000. Therefore, in
case of low demand, break-even point should be reached as early
as possible so that the concern may start earning profits.

m
co
2. Introduction Of A New Product

s.
Sometimes, a product may be added to the existing lines of products
bu
with a view to utilise idle facilities, to capture a new market or for any
other purpose. The profitability of this new product has to be found out
la

initially. Usually, the new product will be manufactured if it is capable


of contributing something toward fixed costs and profit after meeting its
yl

variable costs.
lls

Illustration 5:
.a
w

A concern manufacturing product x has provided the following


w

information:
Rs.
w

Sales 75,000
Direct materials 30,000
Direct labour 10,000
Variable overhead 10,000
Fixed overhead 15,000
In order to increase its sales by rs.25,000, the concern wants to introduce
the product y, and estimates the costs in connection therewith as under:

Direct materials 10,000


Direct labour 8,000
Variable overhead 5,000

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Fixed overhead Nil


Advise whether the product Y will be profitable or not.

Solution:

Marginal Cost Statement


(in Rupees)
X Y Total

Sales 75,000 25,000 1,00,000


Less: marginal costs:
Direct materials 30,000 10,000 40,000
Direct labour 10,000 8,000 18,000

m
Variable overhead 10,000 5,000 15,000

co
50,000 23,000 73,000
s.
bu
Contribution 25,000 2,000 27,000
Fixed cost 15,000
la

Profit 12,000
yl
lls

Commentary: if product Y is introduced, the profitability of product X


is not affected in any manner. On the other hand, product Y provides a
.a

contribution of Rs.2,000 Towards fixed cost and profit. Therefore, Y should


w

be introduced.
w

3. Level Of Activity Planning


w

Marginal costing is of great help while planning the level of activity.


Maximum contribution at a particular level of activity will show the
position of maximum profitability.

Illustration 6:

Following is the cost structure of sundaram corporation,


pondicherry, manufacturers of colour tvs.

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Level of activity
50% 70% 90%
Output (in units ) 200 280 360
Cost (in rs.)
Materials 10,00,000 14,00,000 18,00,000
Labour 3,00,000 4,20,000 5,40,000
Factory overhead 5,00,000 6,00,000 7,00,000

Factory Cost 18,00,000 24,20,000 30,40,000

In view of the fact that there will be no increase in fixed costs

m
and import license for the picture tubes required in the manufacture of

co
its tvs has been obtained, the corporation is considering an increase in
production to its full installed capacity.
s.
The management requires a statement showing all details of
bu
production costs at 100% level of activity.
la

Solution:
Marginal Cost Statement
yl

(At 100% Level Of Activity Total Cost Cost Per Unit


lls

With 400 Units) Rs. Rs.


Materials 20,00,000 5,000
.a

Labour 6,00,000 1,500


w

Variable Factory Overhead 5,00,000 1,250


w

Marginal Factory Cost 31,00,000 7,750


w

Fixed Factory Overhead 2,50,000 625

Total factory cost 33,50,000 8,375


Thus, the marginal factory cost per unit is rs.7,750 and the total
production cost per unit is rs.8,375.

Commentary:
(i) Calculation Of Variable Factory Overheads Per Unit:
Rs.6,00,000 Rs.5,00,000
= --------------------------------- = Rs.1,250
80 Units

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(II) Calculation Of Fixed Factory Overheads:


Factory Overheads (No. Of Units At Certain Level Of Activity X Variable
Factory Overheads Per Unit).
Therefore Rs.5,00,000 (200 Units X 1,250)
Therefore Rs.5,00,000 Rs.2,50,000 = Rs.2,50,000
The Amount Can Be Verified By Making Calculation At Any Other Level
Of Activity.
(III) Variable Factory Overheads At 100% Level Of Activity:
400 Units X 1,250 = Rs.5,00,000

4. Key Factor

A concern would produce and sell only those products which offer

m
maximum profit. This is based on the assumption that it is possible to

co
produce any quantity without any difficulty and sell likewise. However, in
actual practice, this seems to be unrealistic as several constraints come in
s.
the way of manufacturing as well as selling. Such constraints that come in
bu
the way of managements efforts to produce and sell in unlimited quantities
are called `key factors or `limiting factors. The limiting factors may be
la

materials, labour, plant capacity, or demand. Management must ascertain


the extent of the influence of the key factor for ensuring maximisation
yl

of profit. Normally, when contribution and key factors are known, the
lls

relative profitability of different products or processes can be measured


with the help of the following formula:
.a
w

Contribution
w

Profitability = -----------------------
Key Factor
w

Illustration 7: from the following data, which product would you


recommend to be manufactured in a factory, time, being the key factor?
Per Unit of Per Unit of
Product X Product Y

Direct Material 24 14
Direct Labour At Re.1 Per Hour 2 3
Variable Overhead At Rs.2 Per Hour 4 6
Selling Price 100 110
Standard Time To Produce 2 Hours 3 Hours

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Solution:
Per Unit of Per Unit of
Product X Product Y

Selling Price 100 110


Less: Marginal Cost:
Direct Materials 24 14
Direct Labour 2 3
Variable Overhead 4 30 6 23
-- --- -- ---
Contribution 70 87
Standard Time To Produce 2 Hours 3 Hours
Contribution Per Hour 70/2 87/3

m
= Rs.35 = Rs.29

co
Contribution per hour of product x is more than that of product y by
rs.6. Therefore, product x is more profitable and is recommended to be
manufactured. s.
bu
5. Make Or Buy Decisions
la

A company might be having unused capacity which may be utilized


yl

for making component parts or similar items instead of buying them


lls

from the market. In arriving at such a `make or buy decision, the cost of
manufacturing component parts should be compared with price quoted
.a

in the market. If the variable costs are lower than the purchase price, the
w

component parts should be manufactured in the factory itself. Fixed costs


w

are excluded on the assumption that they have been already incurred, and
the manufacturing of components involves only variable cost. However,
w

if there is an increase in fixed costs and any limiting factor is operating


while producing components etc. That should also be taken into account.
Consider the following illustration, throwing light on these aspects.

Illustrations 8:

You are the management accountant of XYZ CO. Ltd. The


Managing director of the company seeks your advice on the following
problem: the company produces a variety of products each having a number
of computer parts. Product B takes 5 hours to produce on machine no.99

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working at full capacity. bB has a selling price of rs.50 and a marginal


cost, Rs.30 per unit. A-10 a component part could be made on the same
machine in 2 hours for marginal cost of Rs.5 per unit. The suppliers price
is Rs.12.50 per unit. Should the company make or buy A10?
Assume that machine hour is the limiting factor.

Solution:

In this problem the cost of new product plus contribution lost


during the time for manufacturing A-10 should be compared with the
suppliers price to arrive at a decision.
Rs.
B Selling Price 50.00

m
Marginal Cost 30.00

co
-------
20.00
------- s.
bu
It takes 5 hours to produce one unit of B.
Therefore, contribution earned per hour on machine no.99 is Rs.20/5 =
la

Rs.4. A-10 takes two hours to be manufactured on machine which is


producing B. Real cost of A-10 to the company = marginal cost of aA-
yl

10 plus contribution lost for using the machine for A-10.


lls

Rs.5 + Rs.8 = Rs.13


.a

This is more than the sellers price of rs.12.50 and so it is advisable for the
w

company to buy the product from outside.


w

Illustration 9:
w

A t.V. Manufacturing company finds that while it costs Rs.6.25 To


make each component X, the same is available in the market at Rs.4.85
Each, with an assurance of continued supply. The break down of cost is:

Rs.
Materials 2.75 Each
Labour 1.75 Each
Other Variables 0.50 Each
Depreciation And Other Fixed Costs 1.25 Each
6.25

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Should you make or buy?

Solution:

Variable cost of manufacturing is Rs.5; (Rs.6.25 Rs.1.25) but the


market price is Rs.4.85. If the fixed cost of Rs.1.25 is also added, it is not
profitable to make the component. Because there is a saving of Rs.0.15
even in variable cost, it is profitable to procure from outside.

6. Suitable Product Mix/Sales Mix

Normally, a business concern will select the product mix which


gives the maximum profit. Product mix is the ratio in which various

m
products are produced and sold. The marginal costing technique helps

co
management in taking appropriate decisions regarding the product mix,
i.e., in changing the ratio of product mix so as to maximise profits. The
s.
technique not only helps in dropping unprofitable products from the
bu
mix but also helps in dropping unprofitable departments, activities etc.
Consider the following illustrations:
la

Illustration 10: (Product Mix)


yl
lls

The following figures are obtained from the accounts of a


departmental store having four departments.
.a
w

Departments
w

(Figures In Rs.)
Particulars A B C D Total
w

Sales 5,000 8,000 6,000 7,000 26,000



Marginal Cost 5,500 6,000 2,000 2,000 15,500
Fixed Cost 500 4,000 1,000 1,000 6,500
(Apportioned)
Total Cost 6,000 10,000 3,000 3,000 22,000
Profit/Loss(-) 1,000 (-) 2,000 3,000 4,000 4,000

On the above basis, it is decided to close down dept. B immediately, as the


loss shown is the maximum. After that dept. A will be discarded. What is
your advice to the management?

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Statement Of Comparative Profitability


Departments
Particulars A B C Total D
Sales 5,000 8,000 6,00026,000 7,000
Less:
Marginal Cost 5,500 6,000 2,000 2,000 15,500

Contribution (-) 500 2,000 4,000 5,000 10,500

Fixed Cost 6,500
--------
Profit 4,000

m
--------

co
Commentary:
s.
bu
From the above, it is clear that the contribution of dept. A is negative
and should be discarded immediately. As dept. B provides rs.2,000 towards
la

fixed costs and profits, it should not be discarded.


yl

Illustration 11 (Sales Mix):


lls

Present the following information to show to the management:


.a

(a) the marginal product cost and the contribution per unit; (b) the total
w

contribution and profits resulting from each of the following mixtures:


w

Product Per Unit (Rs.)


w

Direct Materials A 10
B 9
Direct Wages A 3
B 2
Fixed Expenses Rs.800
Variable Expenses Are Allocated To Products As 100% Of Direct Wages.
Rs.
Sales Price A 20
B 15

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Sales Mixtures:
1000 Units Of Product A And 2000 Units Of B
1500 Units Of Product A And 1500 Units Of B
2000 Units Of Product A And 1000 Units Of B

Solution:

(A) Marginal Cost Statement A B


Direct Materials 10 9
Direct Wages 3 2
Variable Overheads (100%) 3 2
--- ---
Marginal Cost 16 13

m
Sales Price 20 15

co
Contribution 4 2
s.
bu
1000 A+ 1500 A+ 2000 A+
(B) Sales Mix 2000 B 1500 B 1000B
la

Choice (I) (II) (III)


(Rs.) (Rs.) (Rs.)
yl
lls

Total Sales (1000 X 20 + (1500 X 20 + (2000 X 20 +


2000 X 15) = 1500 X 15) = 1000 X 15) =
.a

50,000 52,500 55,000


w
w

(1000 X 16 + (1500 X 16 + (2000 X 16 +


2000 X 13) = 1500 X 13) = 1000 X 13) =
w

Less: Marginal Cost 42,000 43,500 45,000


------------------------------------------------------------
Contribution 8,000 9,000 10,000
Less: fixed costs 800 800 800
------------------------------------------------------------
Profit 7,200 8,200 9,200

Therefore sales mixture (iii) will give the highest profit; and as such,
mixture (iii) can be adopted.

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7. Pricing Decisions

Marginal costing techniques help a firm to decide about the prices


of various products in a fairly easy manner. Lets examine the following
cases:

(I) Fixation of Selling Price

Illustration 12:

P/V Ratio Is 60% and the marginal cost of the product is Rs.50.
What will be the selling price?

m
Solution:

co
S V V C
P/V Ratio = ---------- = 1 - ----- = -----
S s. S S
bu
Variable Cost 40
---------------- = 40% or ------
la

Sales 100
50 50 X 100
yl

Selling Price = ------- = -------------- = Rs.125


lls

40% 40
.a

(ii) Reducing Selling Price


w
w

Illustration 13:
w

The Price Structure Of A Cycle Made By The Visu Cycle Co. Ltd. Is
As Follows: Per Cycle
Materials 60
Labour 20
Variable Overheads 20
-----
Fixed Overheads 100
Profit 50
Selling Price 50
-----
200

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This is based on the manufacture of one lakh cycles per annum.


The company expects that due to competition they will have to reduce
selling prices, but they want to keep the total profits intact. What level of
production will have to be reached, i.e., how many cycles will have to be
made to get the same amount of profits, if:
(a) the selling price is reduced by 10%?
(b) the selling price is reduced by 20%?

Solution:
(Rs.) (Rs.)
Existing profit = 1,00,000 x 50 = 50,00,000
Total fixed overheads = 1,00,000 x 50 = 50,00,000
(a) Selling price is reduced by 10% and to get the existing profit of rs.50

m
lakhs.

co
New Selling Price = 200 10% Of Rs.200
= 200 20 =Rs.180
New Contribution = s.
180 100 =Rs.80 Per Unit
bu
Total Sales (Units) = F + P/Contribution Per Unit
5,00,000 + 5,00,000
la

= ---------------------------
80
yl

= 1,25,000 Cycles
lls

Are to be obtained and sold to earn the existing profit of rs.5,00,000.


(b) Selling price reduced by 20% and to get the existing profit of rs.5,00,000.
.a

New Selling Price = 200 20% Of Rs.200


w

= 200 40 = Rs.160
w

New Contribution = SV
= 160 100 = Rs.80 Per Unit
w

Total Sales (Units) = F + P/Contribution Per Unit


5,00,000 + 5,00,000
= ---------------------------
60
= 1,66,667 cycles are to be produced
and sold to earn the existing profit of rs.50 Lakhs.

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(iii) Pricing During Recession:

Illustration 14:

SSA company is working well below normal capacity due to


recession. The directors of the company have been approached with an
enquiry for special job. The costing department estimated the following in
respect of the job.

Direct Materials Rs.10,000


Direct Labour 500 Hours @ Rs.2 Per Hour
Overhead Costs: Normal Recovery Rates
Variable Re.0.50 Per Hour

m
Fixed Re.1.00 Per Hour

co
The directors ask you to advise them on the minimum price to be charged.
Assume that there are no production difficulties regarding the job.
s.
bu
Solution:
la

Calculation Of Marginal Cost:


(Rs.)
yl

Direct Materials 10,000


lls

Direct Labour 1,000


Variable Overhead @ Re.0.50 Per Hour 250
.a

---------
w

Marginal Cost 11,250


w

---------
Commentary:
w

Here the minimum price to be quoted is Rs.11,250 which is the


marginal cost. By quoting so, the company is sacrificing the recovery of
the profit and the fixed-costs. The fixed costs will continue to be incurred
even if the company does not accept the offer. So any price above Rs.11,250
is welcome.

7. Accepting Foreign Order

Marginal costing technique can also be used to take


a decision as to whether to accept a foreign offer or not. The speciality of

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this situation is that normally foreign order is requiring the manufacturer


to supply the product at a price lower than the inland selling price. Here
the decision is taken by comparing the marginal cost of the product with
the foreign price offered. If the foreign order offers a price higher than
the marginal cost then the offer can be accepted subject to availability
of sufficient installed production capacity. The following illustration
highlights this decision:

Illustration 15:

Due to industrial depression, a plant is running at present at


50% of the capacity. The following details are available:
Cost Of Production Per Unit (Rs.)

m
Direct Materials 2

co
Direct Labour 1
Variable Overhead 3
Fixed Overhead 2 s.
bu
---
8
la

---
Production Per Month 20,000 Units
yl

Total Cost Of Production Rs.1,60,000


lls

Sale Price Rs.1,40,000


--------------
.a

Loss Rs.20,000
w

--------------
w

An exporter offers to buy 5000 units per month at the rate of rs.6.50 per
w

unit and the company is hesitant to accept the order for fear of increasing
its already large operating losses. Advise whether the company should
accept or decline this offer.

Solution:

At present the selling price per unit is Rs.7/- and the marginal cost
per unit is Rs.6/- (Material Rs.2 + Labour Re.1 + Variable Overhead Rs.3).
The foreign order offers a price of Rs.6.50 and there is ample production
capacity (50%) available. Since the foreign offer is at a price higher than
marginal cost the offer can be accepted. This is proved hereunder:

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(Rs.)
Marginal Cost Of 5000 Units = 5000 X 6 = 30,000
Sale Price Of 5000 Units = 5000 X 6.50 =32,500
--------
Profit 2,500
--------
Thus by accepting the foreign order the present loss of Rs.20,000 would be
reduced to Rs.17,500 I.E., Rs.20000 Loss Rs.2,500 Profit.

4.1.3.4 Limitations Of Marginal Costing


Marginal costing has the following limitations:

1.difficulty in classification:

m
co
In marginal costing, costs are segregated into
Fixed and variable. In actual practice, this classification scheme proves to
be s.
bu
Superfluous in that, certain costs may be partly fixed and partly variable
and
la

Certain other costs may have no relation to volume of output or even


with the time. In short, the categorisation of costs into fixed and variable
yl

elements is a difficult and tedious job.


lls

2.Difficulty In Application:
.a
w

the marginal costing technique cannot be applied in industries


w

where large stocks in the form of work-in-progress (job and contracting


firms) are maintained.
w

3.Defective Inventory Valuation:

under marginal costing, fixed costs are not included in the value of
finished goods and work in progress. As fixed costs are also incurred, these
should form part of the cost of the product. By eliminating fixed costs
from finished stock and work-in-progress, marginal costing techniques
present stocks at less than their true value. Valuing stocks at marginal cost
is objectionable because of other reasons also:

1. In case of loss by fire, full loss cannot be recovered from the

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insurance company.
2. Profits will be lower than that shown under absorption costing
andhence may be objected to by tax authorities.
3. Circulating assets will be understated in the balance sheet.

4.Wrong Basis For Pricing:

In marginal costing, sales prices are arrived at on the basis of


contribution alone. This is an objectionable practice. For example, in the
long run, the selling price should not be fixed on the basis of contribution
alone as it may result in losses or low profits. Other important factors such
as fixed costs, capital employed should also be taken into account while
fixing selling prices. Further, it is also not correct to lay more stress on

m
selling function, as is done in marginal costing, and relegate production

co
function to the backgroud.

5.Limited Scope: s.
bu
The utility of marginal costing is limited to short-run profit
la

planning and decision-making. For decisions of far-reaching importance,


one is interested in special purpose cost rather than variable cost. Important
yl

decisions on several occasions, depend on non-cost considerations also,


lls

which are thoroughly discounted in marginal costing.


In view of these limitations, marginal costing needs to be applied with
.a

necessary care and caution. Fruitful results will emerge only when
w

management tries to apply the technique in combination with other useful


w

techniques such as budgetary control and standard costing.


w

4.1.3.5 Additional Illustrations

Illustration 16:

from the following information, find out the amount of profit earned
during the year, using marginal cost equation:
Fixed Cost Rs.5,00,000
Variable Cost Rs.10 Per Unit
Selling Price Rs.15 Per Unit
Output Level 1,50,000 Units

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Solution:

Contribution = Selling Price Variable Cost


=(1,50,000 X 15) (1,50,000 X 10)
= Rs.22,50,000 Rs.15,00,000
= Rs.7,50,000
Contribution = Fixed Cost + Profit
Rs.7,50,000 = 5,00,000 + Profit
Profit = 7,50,000 5,00,000
= (C F)
Profit = Rs.2,50,000

Illustration 17:

m
co
Determine the amount of fixed costs from the following details,
using the marginal cost equation.
s.
bu
Sales Rs.2,40,000
Direct Materials Rs. 80,000
la

Direct Labour Rs. 50,000


Variable Overheads Rs. 20,000
yl

Profit Rs. 50,000


lls

Solution:
.a
w

Marginal Costing Equation = S V = F + P


w

= 2,40,000 1,50,000
= F + P
w

= 90,000
= F + 50,000
F = 90,000 50,000
F = Rs.40,000

Illustration 18:

Sales 10,000 Units @ Rs.25 Per Unit


Variable Cost Rs.15 Per Unit
Fixed Costs Rs.1,00,000
Find Out The Sales For Earning A Profit Of Rs.50,000

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Solution:

Sales To Earn A Profit Of Rs.50,000


(Fixed Cost + Profit) Sales
= ----------------------------------
Sales Variable Cost
1,00,000 + 50,000 X 2,50,000
= -------------------------------------
2,50,000 1,50,000
1,50,000 X 2,50,000
= ---------------------------
1,00,000
= Rs.3,75,000

m
co
Illustration 19:

s.
The records of ram ltd., Which has three departments give the following
bu
figures:
Dept. A Dept. B Dept. C Total
la

(Rs.) (Rs.) (Rs.) (Rs.)


Sales 12,000 18,000 20,000 50,000
yl

-------------------------------------------------------------
lls

Marginal Cost 13,000 6,000 15,000 34,000


Fixed Cost 1,000 4,000 10,000 15,000
.a

-------------------------------------------------------------
w

Total Cost 14,000 10,000 25,000 49,000


w

Profit/Loss -2,000 +8,000 -5,000 1,000


The management wants to discontinue product c immediately as it gives
w

the maximum loss. How would you advise the management?

Solution:

Marginal Cost Statement


Particulars A B C Total
(Rs.) (Rs.) (Rs.) (Rs.)
---------------------------------------------------------------------------------
Sales 12,000 18,000 20,000 50,000
Less: Marginal Cost 13,000 6,000 15,000 34,000
-------------------------------------------------------------

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Contribution -1,000 12,000 5,000 16,000


Fixed Cost 15,000
---------
Profit 1,000

Here department A gives negative contribution, and as such it can be given


up. Department C gives a contribution of Rs.5,000. If department C is
closed, then it may lead to further loss. Therefore, C should be continued.

Summary

Marginal costing is an important technique of costing where only


variable costs are considered while calculating the cost of the product.

m
It is a technique of presenting cost information and can be used with

co
other methods of costing (such as job costing, contract costing, etc). This
technique can be applied while taking decisions relating to profit planning,
s.
introducing a new product, level of activity planning, allocating scarce
bu
factors to profitable channels, make or buy decisions, suitable production/
sales mix, fixing prices for products, etc. However this technique is not
la

without limitations.
yl

4.1.3.7 Key Words


lls

Marginal costing: the change in total cost because of change in total output
.a

by one unit which is otherwise called as variable cost.


w
w

Contribution: the excess of selling price over variable cost.


Profit volume ratio: it shows the relationship between contribution and
w

sales.

Break even point: it is that point of sales at which there is no profit or no


loss i.e. Where total revenues and total costs are equal.

Margin of safety: excess of actual sales over break-even sales.


Marginal cost equation:
SV=C
C=F+P

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4.1.3.8 Self Assessment Questions

1. Define marginal cost.


2. What is meant by contribution? Explain its significance.
3. Explain the following:
Profit Volume Ratio
Break Even Point
Margin Of Safety
4. Explain how marginal costing technique is useful as a decision making
tool.
5. Critically evaluate marginal costing technique.
6. Break-down of cost per unit at an activity level of 10,000 units of a
company is as follows:

m
Rs.

co
Raw materials 10
Direct expenses 8
Chargeable expenses s. 2
bu
Variable overheads 4
Fixed overheads 6
la

---
Total cost per unit 30
yl

Selling price 32
lls

---
Profit per unit 2
.a

---
w
w

How many units must be sold to break-even?


7. Tamarai ltd., gives you the following information:
w

Sales Profit
Rs. Rs.
Period I 1,50,000 20,000
Period II 1,70,000 25,000
Calculate:
(a) the p/v ratio.
(b) the profit when sales are rs.2,50,000
(c) the sales required to earn a profit of rs.40,000
(d) the break-even point.
8. Production costs of selvi enterprises limited are as follows:

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Level of Activity

Output (In %Ge) 60% 70% 80%


Output (In Units) 1,200 1,400 1,600
------------------------------------------------
Direct Materials 24,000 28,000 32,000
Direct Labour 7,200 8,400 9,600
Factory Overheads 12,800 13,600 14,400
------------------------------------------------
Works Cost 44,000 50,000 56,000
------------------------------------------------

A proposal to increase production to 90% level of activity is under

m
consideration of the management. The proposal is not expected to involve

co
any increase in fixed factory overheads.
[Hint: fixed factory overheads rs.8,000]
s.
bu
9. The following expenses are incurred in the manufacture of 1,000 units
of a product in the manufacture of which a factory specialises:
la

Raw materials 2,800


Wages 1,900
yl

Overhead charges (rs.4,000 fixed) 4,200


lls

10,000 units of the product can be absorbed by the home market where
the selling price is rs.9 per unit. There is a demand for 50,000 units of the
.a

product in a foreign market if it can be offered at rs.8.20 per unit. If


w

This is done, what will be the total profit or loss made by the manufacturer?
w

10. The following data are obtained from the records of a factory:
w

Rs. Rs.
Sales 4000 units @ rs.25 Each 1,00,000
Less: marginal cost
Materials consumed 40,000
Labour charges 20,000
Variable overheads 12,000
--------
72,000
Fixed cost 18,000 90,000
--------- ----------
Profit 10,000
----------

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It is proposed to reduce the selling price by 20%. What extra units


should be sold to obtain the same amount of profit as above?

4.1.3.9 Key To Self Assessment Questions


(for problems only)

Q.No.6: 7500 Units.


Q.No.7: (A) 25%; (B) Rs.45,000; (C) Rs.2,30,000; (D) Rs.70,000.
Q.No.8: Prime Cost Rs.46,800; Marginal Cost Rs.54,000; Works Cost
Rs.62,000.
Q.No.9: Profit Rs.2,02,000.
Q.No.10: 10,000 Units.

m
co
4.1.3.10 Case Analysis

s.
The cost per unit of the three products x, y and z of a concern is
bu
As follows:
la

X Y Z
(Rs.) (Rs.) (Rs.)
yl

Direct Material 6 7 6
lls

Direct Labour 10 8 9
Variable Expenses 4 5 3
.a

Fixed Expenses 3 3 2
w

--------------------------------------------
w

23 23 20
Profit 9 7 6
w

--------------------------------------------
Selling Price 32 30 26
--------------------------------------------
No. Of Units Produced 10,000 5,000 8,000

Production arrangements are such that if one product is given up, the
production of the others can be raised by 50%. The directors propose that
z should be given up because the contribution in that case is the lowest.
Analyse the case and give your opinion.

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Solution:

Statement of projected profitability with products x and y


X Y

Production (In Units) 10000 5000


Add 50% Increase (Proposed) 5000 2500
15000 7500
Selling Price Per Unit 32 30
--------------------------
Less: variable cost per unit
Materials 6 7
Labour 10 8

m
Variable expenses 4 5

co
20 20
Contribution per unit 12 10
s.
bu
Total contribution
X 15000 Units X Rs.12 = Rs.1,80,000
la

Y 7500 Units X Rs.10 = Rs. 75,000


Rs.2,55,000
yl

Less: Fixed Cost


lls

X 10000 X 3 = 30000
Y 5000 X 3 = 15000
.a

Z 8000 X 2 = 16000 Rs. 61,000


w

------- --------------
w

Projected Profit = Rs.1,94,000


--------------
w

Statement Of Present Profit With Products X, Y And Z


Rs.
Product X = 10000 Units X Rs.9 = 90,000
Product Y = 5000 Units X Rs.7 = 35,000
Product Z = 8000 Units X Rs.6 = 48,000
------------
1,73,000
----------
Since by discontinuing product z and increasing the production of products
X andY the profit increases from Rs.1,73,000 to Rs.1,94,000. The directors
proposal may be implemented.

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4.1.3.11 Books For Further Reading

1. P.Das Gupta: Studies In Cost Accounting, Sultan Chand & Sons, New
Delhi.
2. Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.
3. Jawaharlal: Advanced Management Accounting, S.Chand & Co.
4. S.N.Maheswari: Management Accounting And Financial Control,
Sultan
5. Chand & Sons.
6. V.K.Saxena And C.D.Vashist: Advanced Cost And Management
Accounting, Sultan Chand & Sons, New Delhi.

m
*****

co
s.
bu
la
yl
lls
.a
w
w
w

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m
co
s.
bu
la
yl
lls
.a
w
w
w

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Lesson 4.2 - Cost Volume Profit Analysis

4.2.1 Introduction

The cost of a product consists of two items: fixed cost and variable
cost. Fixed costs are those which remain the same in total amount regardless
of changes in volume. Variable costs are those which vary in total amount
as the volume of production increases or decreases. As a result, at different
levels of activity, the cost structure of a firm changes. The effect on profit
on account of such variations is studied through break even analysis or

m
cost-volume-profit analysis. This lesson deals with the various concepts,

co
tools and techniques of cost-volume profit analysis.

4.2.2 Learning Objectives s.


bu
After reading this lesson, the reader should be able to:
la

understand the meaning of cost-volume-profit analysis.


yl

apply cost-volume-profit analysis while taking decisions.


lls

construct the break-even chart.


evaluate the advantages and limitations of break-even analysis.
.a

4.2.3 Contents
w
w

4.2.3.1 Meaning Of Cost-Volume-Profit Analysis


w

4.2.3.2 Application Of Cost-Volume-Profit Analysis


4.2.3.3 Break Even Chart
4.2.3.4 Consultation Of Break Even Chart
4.2.3.5 Profit Volume Graph
4.2.3.6 Advantages And Limitations Of Break Even Analysis
4.2.3.7 Summary
4.2.3.8 Key Words
4.2.3.9 Self Assessment Questions
4.2.3.10 Key To Self Assessment Questions
4.2.3.11 Case Analysis
4.2.3.12 Books For Further Reading

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4.2.3.1 Meaning of Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis focuses on the way cost and


profit change when volume changes. It is, broadly speaking, that system of
analysis which determines the probable profit at any level of activity. This
technique is generally used to analyse the incremental effect of volume on
costs, revenues and profits. At what volume of operations are costs and
revenues equal? What volume of output or sales would be necessary to earn
a profit of say rs.2 lakhs? How much profit will be earned at a volume of,
say 10,000 units? What will happen if there is a reduction of 10 percent in
the selling price? Questions like these are sought to be answered through
cvp analysis. This detailed analysis will help the management to know the

m
profit levels at different activity levels of production and sales and various

co
types of costs involved in it.

s.
4.2.3.2 Application Of Cost-Volume-Profit Analysis
bu
CPV analysis helps in:
la

Forecasting the profit in an accurate manner


Preparing the flexible budgets at different levels of activity
yl

Fixing prices for products


lls

Illustration 1:
.a

(Profit Planning) based on the following information, find out the break
w

even point, the sales needed for a profit of rs.6,00,000 and the profit if
w

4,00,000 units are sold at rs.6 per unit.


w

Units Of Output 5,00,000


Fixed Costs Rs.7,50,000
Variable Cost Per Unit Rs. 2
Selling Price Per Unit Rs. 5

Solution:
(1)Break-Even Point (Of Sales)
Fixed Costs
= -------------------------- X Selling Price Per Unit
Contribution Per Unit

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7,50,000
= ------------- x 5 = Rs.12,50,000
3
(2) Sales Needed For A Profit Of Rs.6,00,000
Fc + Desired Profit
Sales = --------------------------
P/V Ratio
7,50,000 + 6,00,000
= ---------------------------
3/5

5
= 13,50,000 X -----

m
3

co
= Rs.22,50,000 [or]
22,50,000
= --------------- s.
bu
(SP) 5
= 4,50,000 Units
la

(3) Profit On Sale Of 4,00,000 Units At Rs.6 Per Unit


Sales = 4,00,000 Units
yl

= 4,00,000 X Rs.6
lls

= Rs.24,00,000
.a

Sales V. Cost = Contribution


w

24 Lakhs (4 Lakhs X 2 Per Unit) = 16,00,000


w

C Fc = Profit
16,00,000 7,50,000 = Rs.8,50,000 [Or]
w

Unit Sales X Contribution Per Unit Fc


4 Lakhs X Rs.4 = 16 Lakhs 7,50,000 = 8,50,000

Illustration 2: (Pricing)

A company is considering a reduction in the price of its product by


10% because it is felt that such a step may lead to a greater volume of sales.
It is anticipated that there will be no change in total fixed costs or variable
costs per unit. The directors wish to maintain profit at the present level.

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You are given the following information:


Sales (15,000 Units) Rs.3,00,000
Variable Cost Rs.13 Per Unit
Fixed Cost Rs.60,000
From the above information, calculate P/V ratio and the amount of sales
required to maintain profit at the present level after reduction of selling
price by 10%.

Solution:
S V 3,00,000 (15,000 X 13)
P/V Ratio = ---------- = -------------------------------
S 3,00,000
= 0.35 Or 35%

m
After reduction of price by 10% it will be Rs.18 (original price per unit

co
Rs.20).
Present profit level = (35% of 3,00,000) 60,000
= Rs.45,000 s.
bu
P/v ratio after price reduction
S V 18 13 5
la

= -------- = ---------- = ---- %


S 18 18
yl

To earn the same profit level


lls

F + Desired Profit
= ------------------------
.a

P/V Ratio
w

18
w

= 1,05,000 X ------
5
w

= Rs.3,78,000

Illustration 3:

From the following data, calculate the break-even point.


First year Second Year
Sales 80,000 90,000
Profit Rs.10,000 Rs.14,000

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Solution:
Fixed Costs
Bep Sales = ----------------
P/V Ratio
Change In Profit
P/V Ratio = -------------------- X 100
Change In Sales

4,000
= --------- X 100 = 40%
10,000

m
Fixed Cost = Contribution Profit

co
40
= 80,000 X ------ Rs.10,000
100 s.
bu
= 32,000 10,000
= 22,000
la

22,000 X 100
yl

Bep Sales = ---------------- = Rs.55,000


lls

40
Illustration 4:
.a
w

A company is considering expansion. Fixed costs amount to


w

rs.4,20,000 and are expected to increase by rs.1,25,000 when plant


expansion is completed. The present plant capacity is 80,000 units a year.
w

Capacity will increase by 50 percent with the expansion. Variable costs


are currently rs.6.80 per unit and are expected to go down by re.0.40 per
unit with the expansion. The current selling price is rs.16 per unit and is
expected to remain the same under either alternative. What are the break-
even points under either alternatives? Which alternative is better and why?

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Solution:

Computation of BEP Under Two Alternatives


Items Currently Afterthexpansion
Rs. Rs.
---------------------------------------------------------------------------------
Fixed Costs 4,20,000 5,45,000
Capacity 80,000 Units 1,20,000Units
Variable Cost Per Unit 6.80 6.40
Contribution Margin Per Unit 9.20 9.60
Selling Price Per Unit 16 16

4,20,000 5,45,000

m
BEP = ------------ -----------

co
9.20 9.60
= 45,652 Units = 56,771 Units
s.
---------------------------------------------------------------------------------
bu
Assuming that the whole production can be sold, the profit under
la

The two alternatives will be:


yl

Items Currently After The Expansion


lls

Sales 12,80,000 19,20,000


- Variable Cost 5,44,000 7,68,000
.a

------------ ------------
w

Contribution 7,36,000 11,52,000


w

- Fixed Cost 4,20,000 5,45,000


------------ ------------
w

3,16,000 6,07,000
------------ ------------
---------------------------------------------------------------------------------

It is obvious from the above calculations that the profits will be almost
double after the expansion. Hence, the alternative of expansion is to be
preferred.

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Illustration 5:

A factory engaged in manufacturing plastic buckets is working at


40% capacity and produces 10,000 buckets per annum:
Rs.
Material 10
Labour cost 3
Overheads 5 (60% fixed)
The selling price is rs.20 per bucket.
If it is decided to work the factory at 50% capacity, the selling price falls by
3%. At 90% capacity the selling price falls by 5%, accompanied by a similar
fall in the prices of material.
You are required to calculate the profit at 50% and 90% capacities and also

m
the break-even points for the same capacity productions.

co
Solution:
s.
bu
Statement showing profit and break-even point at different capacity levels:
Capacity Level 50% 90%
la

Production (Units) 12,500 22,500


Per Unit Total Per Unit Total
yl

Rs. Rs. Rs. Rs.


lls

---------------------------------------------------------------------------------
.a

(A) Sales 19.40 2,42,500 19.00 4,27,500


w

Variable Cost
w

Materials 10.00 1,25,000 9.50 2,13,750


Wages 3.00 37,500 3.00 67,500
w

Variable
Overhead 2.00 25,000 2.00 45,000
---------------------------------------------------------------------------------
(B)Total Variable Cost 15.00 1,87,500 14.50 3,26,250
---------------------------------------------------------------------------------
(C) Contribution
(S-V) 4.40 55,000 4.50 1,01,250
Or (a-b)
Less Fixed Cost 30,000 30,000
---------- ----------
25,000 71,250
---------- --------

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Break-even points at 50% at 90%


Fixed Costs
Units = ---------------------------
Contribution Per Unit
30,000 30,000
= ---------- = 6818 ---------- = 6667
4.40 4.50
Sales Value = Rs.1,32,269 = Rs.1,26,667

Illustration 6:

Calculate:
The amount of fixed expenses

m
The number of units to break-even

co
The number of units to earn a profit of rs.40,000
The selling price can be assumed as rs.10.
s.
The company sold in two successive periods 9,000 units and 7,000
bu
units and has incurred a loss of rs.10,000 and earned rs.10,000 as profit
respectively.
la

Solution:
yl
lls

Year Sales Profit/Loss


I 7,000 Units Rs. (- )10,000
.a

II 9,000 Units Rs. (+)10,000


w

------- ----------
w

2,000 20,000 (Change)


------- ----------
w

Year I Year II
(I) Contribution = 9,000Units X Rs.10 7,000Units Xrs.10
= Rs. 90,000 = Rs. 70,000
Less: Profit/Loss = Rs. -10,000 = Rs.+10,000
----------- --------------
Fixed Cost = Rs. 80,000 = Rs. 80,000
(Contribution = Fixed Cost + Profit)

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Rs.20,000
(Ii) Contribution = --------------- = Rs.10 Per Unit
2,000 Units

FC Rs.80,000
BEP = --------- = ------------- = 8,000 Units
C Rs.10
(Iii) The No. Of Units To Earn A Profit Of Rs.40,000
F + Desired Profit
= -----------------------
C Per Unit
80,000 + 40,000
= --------------------- = 12,000 Units

m
10

co
Illustration 7:

From The Following Data Calculate: s.


bu
P/V Ratio
Profit When Sales Are Rs.20,000
la

Net Break-Even If Selling Price Is Reduced By 20%


Fixed Expenses Rs.4,000
yl

Break-Even Point 10,000


lls

Solution:
.a

Fixed Expenses
w

(I) Break-Even Sales = --------------------


w

P/V Ratio
Fixed Expenses
w

or P/V Ratio = ----------------------


Break-Even Sales
4,000
= -------- = 40%
10,000

(II) Profit When Sales Are Rs.20,000


Profit = Sales X P/V Ratio Fixed Expenses
= Rs.20,000 X 40% Rs.4,000
= Rs. 8,000 Rs.4,000
= Rs. 4,000

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(III) New Break-Even Point If Selling Price Is Reduced By 20%


If Selling Price Is Rs.100, Now It Will Be Rs.80
V. Cost Per Unit = Rs.60 (I.E., 100 40% Old P/V Ratio)

80 60
New P/V Ratio = ---------- = 25%
80

4,000
Break-Even Point = ------- = Rs.16,000
25%

m
Illustration 8:

co
From the following data calculate:
s.
Break-even point in amount of sales in rupees.
bu
Number of units that must be sold to earn a profit of Rs.60,000
Per year.
la

How many units must be sold to earn a net profit of 15% of sales?
yl

Sales Price Rs.20 Per Unit


lls

Variable manufacturing costs Rs.11 per unit


Variable selling costs Rs. 3 per unit
.a

Fixed factory overheads Rs.5,40,000


w

Fixed selling costs Rs.2,52,000


w

Solution:
w

---------------------------------------------------------------------------------
(I) Items Per Unit Total Fixed Cost
Rs. Rs.
---------------------------------------------------------------------------------
Sales Price 20 Factory Overheads 5,40,000
Variable Costs Selling Costs 2,52,000

Manufacturing 11 7,92,000
Selling 3 14
-- ---
Contribution Per Unit 6

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Fixed Costs 7,92,000


BEP = ------------------------- = ------------
Contribution Per Unit 6
= 1,32,000 Units
Total Sales = 1,32,000 X Rs.20 = 26,40,000

Fixed Cost + Desired Profit 7,92,000 + 60,000


(II) ----------------------------------- = -----------------------
Contribution per unit 6

8,52,000
= -----------
6

m
= 1,42,000 units

co
(III) Let The No. Of Units Sold Be X.
Marginal Cost Equation: s.
bu
= S V =F+P
= 20X 14X = F + 15% Of Sales
la

= 20 X 14 X = 7,92,000 + 15% Of 20X


= 6 X = 7,92,000 + 3 X
yl

= 6 X 3 X = 7,92,000
lls

= 3 X = 7,92,000
.a

7,92,000
w

X= No. Of Units = ------------


w

3
= 2,64,000
w

2,64,000 X Rs.20 X 15
Profit = --------------------------- = Rs.7,92,000
100

4.2.3.3 Break-Even Chart

The break-even point can also be shown graphically through


the break-even chart. The break-even chart `shows the profitability or
otherwise of an undertaking at various levels of activity and as a result
indicates the point at which neither profit nor loss is made. It shows the
relationship, through a graph, between cost, volume and profit. The break-

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even point lies at the point of intersection between the total cost line and
the total sales line in the chart. In order to construct the breakeven chart,
the following assumptions are made:

Assumptions Of Break-Even Chart

1. Fixed costs will remain constant and do not change with the level
of activity.
2. Costs are bifurcated into fixed and variable costs. Variable costs
change according to the volume of production.
3. Prices of variable cost factors (wage rates, price of materials,
suppliers etc.) Will remain unchanged so that variable costs are
truly variable.

m
4. Product specifications and methods of manufacturing and selling

co
will not undergo a change.
5. Operating efficiency will not increase or decrease.
6. s.
Selling price remains the same at different levels of activity.
bu
7. Product mix will remain unchanged.
8. The number of units of sales will coincide with the units produced,
la

and hence, there is no closing or opening stock.


yl

4.2.3.4 Construction Of Break-Even Chart


lls

The following steps are required to be taken while constructing the


.a

Break-even chart:
w
w

1. Sales volume is plotted on the x-axis. Sales volume can be shown


in the form of rupees, units or as a percentage of capacity. A
w

horizontal line is drawn spacing equal distances showing sales at


various activity levels.
2. Y axis represents revenues, fixed and variable costs. A vertical line
is also spaced in equal parts.
3. Draw the sales line from point o onwards. Cost lines may be
drawn in two ways (i) fixed cost line is drawn parallel to x axis and
above it variable cost line is drawn from zero point of fixed cost
line. This line is called the total cost line (fig.1) (ii) in the second
method the variable cost line is drawn from point o and above
this, fixed cost line is depicted running parallel to the variable
cost line. This line may be called total cost line. (fig.2)

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4. The point at which the total cost cuts across the sales line is the
break-even point and volume at this point is break-even volume.
5. The angle of incidence is the angle between sales and the total cost
line. It is formed at the intersection of the sales and the total cost
line, indicating the profit earning capacity of a firm. The wider
the angle the greater is the profit and vice versa. Usually, the angle
of incidence and the margin of safety are considered together to
show that a wider angle of incidence coupled with a high margin
of safety would indicate the most suitable conditions.

Illustration 9:

from the following information, prepare a break-even chart

m
Showing the break-even point.

co
Budget output . 80,000 units
Fixed expenses . Rs.4,00,000
Selling price per unit .. Rs. 20 s.
bu
Variable cost per unit . Rs. 10
la

Solution:
yl

Total costs and sales at varying levels of output:


lls

Output Variable Fixed Total Sales


(Units) Cost Rs. Cost Rs. Cost Rs. Cost Rs.
.a

---------------------------------------------------------------------------------
w

@ 10 p.u. @ 20 p.u.
w

20,000 2,00,000 4,00,000 6,00,000 4,00,000


40,000 4,00,000 4,00,000 8,00,000 8,00,000
w

60,000 6,00,000 4,00,000 10,00,000 12,00,000


80,000 8,00,000 4,00,000 12,00,000 16,00,000

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Fig. 1

m
co
fig. 2

s.
bu
la
yl
lls
.a
w
w
w

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First Method (Fig.1)


Fixed cost line runs parallel to x-axis. Total cost line is drawn at rs.4 lakhs
on y-axis and runs upward. Sales line drawn from point o.
B.E.P. is at 40,000 units, i.e., rs.8,00,000

M/S = Sales B.E. Volume


= 80,000 40,000
= 40,000 Units (I.E. Rs.8,00,000)

Alternative Method (Fig.2)

Variable cost line starts from point o and runs upward. Total cost
Line is drawn parallel to v.c.line from rs.4 lakhs point on y-axis. Total

m
Cost and sales line cut each other at 40,000 units (i.e., rs.8,00,000 sales).

co
This is the break-even point.

Cash Break-Even Chart s.


bu
This chart is prepared to show the cash need of a concern. Fixed
la

expenses are to be classified as those involving cash payments and those not
involving cash payments like depreciation. As the cash break-even chart
yl

is designed to include only actual payments and not expenses incurred,


lls

any time lag in the payment of items included under variable costs must
be taken into account. Equal care must be shown on the period of credit
.a

allowed to the debtors for the purpose of calculating the amount of cash to
w

be received from them, during a particular period.


w

Illustration 10:
w

The following information is available in respect of graphics ltd.,


ghaziabad, for the budget period.
Sales 10,000 units at rs.10 per unit.
Variable costs rs.4 per unit.
Fixed costs rs.25,000 including depreciation of rs.5,000
Preference dividend to be paid rs.5,000
Taxes to be paid rs.5,000
It may be assumed that there are no lags in payment. Prepare a cash
break-even chart.

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Fig.3.
4.2.3.5 Profit Volume Graph

This graph (called profit graph) gives a pictorial representation


of cost-volume profit relationship. In this graph x axis represents sales.
However, the sales line bisects the graph horizontally to form two areas.
The ordinate above the zero sales line, shows the profit area, and the
ordinate below the zero sales line indicates the loss or the fixed cost area.
The profit-volume-ratio line is drawn from the fixed cost point through
the break-even point to the point of maximum profit. In order to construct
this graph, therefore, data on profit at a given level of activity, the break-
even point and the fixed costs are required.

m
Illustration 11:

co
Draw the profit volume graph and find out p/v ratio with the
following information: s.
bu
Output 3,000 units
Volume of sales rs.7,500
la

Variable cost rs.1,500


Fixed cost rs.1,500
yl
lls

Solution:
.a

In the above graph, the profit is rs.1,500. The fixed cost is rs.1,500. Pq
w

represents sales line at point positive, which is the break even point i.e.,
w

rs.3,750. The p/v ratio can easily be found out with the help of this graph
as follows:
w

FXS 1,500 X 7,500


Sales At B.E.P. = --------- = ----------------- Rs.3,750
SV 7,500 4,500
Margin Of Safety = 7,500 3,750 = 3,750

SV 7,500 4,500
P/V Ratio = --------- = -----------------
S 7,500
2
= --- or 0.4 or 40%
5

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( use fig.4)
4.2.3.6 Advantages And Limitations Of Break-Even Analysis

The break-even analysis is a simple tool employed to graphically


represent accounting data. The data revealed by financial statements and
reports are difficult to understand and interpret. But when the same are
presented through break-even charts, it becomes easy to understand them.
Break-even charts help in:

1. Determining total cost, variable cost and fixed cost at a given level
of activity.
2. Finding out break-even output or sales.
3. Understanding the cost, volume, profit relationship.

m
4. Making inter-firm comparisons.

co
5. Forecasting profits.
6. Selecting the best product mix.
7. Enforcing cost control. s.
bu
On the negative side, break-even analysis suffers from the following
limitations:
la

1.It is very difficult if not impossible to segregate costs into fixed and
yl

variable components. Further, fixed costs do not always remain constant.


lls

They have a tendency to rise to some extent after production reaches a


certain level. Likewise, variable costs do not always vary proportionately.
.a

Another false assumption is regarding the sales revenue, which does not
w

always change proportionately. As we all know selling prices are often


w

lowered down with increased production in an attempt to boost up sales


revenue. The break even analysis also does not take into account the
w

changes in the stock position (it is assumed, erroneously though, that


stock changes do not affect the income) and the conditions of growth and
expansion in an organisation.

2.The application of break-even analysis to a multiproduct firm is


very difficult. A lot of complicated calculations are involved.

3.The break-even point has only limited importance. At best it


would help management to indulge in cost reduction in times of dull
business. Normally, it is not the objective of business to break-even,
because no business is carried on in order to break-even. Further the term

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bep indicates precision or mathematical accuracy of the point. However,


in actual practice, the precise break-even volume cannot be determined
and it can only be in the nature of a rough estimate. Therefore, critics have
pointed out that the term `break-even area should be used in place of bep.

4.Break-even analysis is a short-run concept, and it has a limited


application in the long range planning.

Despite these limitations, break-even analysis has some practical utility


in that it helps management in profit planning. According to wheldon,
`if the limitations are accepted, and the chart is considered as being an
instantaneous photograph of the present position and possible trends,
there are some very important conclusions to be drawn from such a chart.

m
co
Summary

s.
Cost-volume-profit analysis is a technique of analysis to study the
bu
effects of cost and volume variations on profit. It determines the probable
profit at any level of activity. It helps in profit planning, preparation of
la

flexible budgets, fixation of selling prices for products, etc.


yl

The break-even point is generally depicted through the break-


lls

even chart. The chart shows the profitability of an undertaking at various


levels of activity. It brings out the relationship between cost, volume and
.a

profit clearly. On the negative side, the limitations of break-even analysis


w

are: difficulty in segregating costs into fixed and variable components,


w

difficulty in applying the technique to multi-product firms, short-term


orientation of the concept etc.
w

Key Words

Cost-volume-profit analysis: it is that system of analysis which determines


the probable profit at any level of activity.
Profit planning: estimating the profit as accurately as possible.
Pricing: fixing prices for products.
Break-even chart: it is that chart which shows the bep graphically.
Cash break-even chart: this chart shows the cash need of a concern.
Profit-volume graph: this chart gives a pictorial representation of cost
volume- profit analysis.

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4.2.3.9 Self Assessment Questions

1. What is meant by cost-volume-profit analysis? Explain its


application in managerial decision making.
2. How would you construct a break-even chart?
3. Make an evaluation of break-even analysis.
4. You are given the following data for the year 1989 of x company.

Rs. %
Variable costs 6,00,000 60
Fixed costs 3,00,000 30
Net profit 1,00,000 10
----------- -----

m
Total sales 10,00,000 100

co
----------- -----
Find out (A) Break-Even Point
(A) P/V Ratio, And s.
bu
(B) Margin Of Safety Ratio
Also draw a break-even chart indicating contribution.
la

A firm is selling x product, whose variable cost per unit is


rs.10 and fixed cost is rs.6,000. It has sold 1,000 articles during one
yl

month at rs.20 per unit. Market research shows that there would be a
lls

great demand for the product if the price can be reduced. If the price can
be reduced to rs.12.50 per unit, it is expected that 5,000 articles can be
.a

sold in the expanded market. The firm has to take a decision whether to
w

produce and sell 1,000 units at the rate of rs.20 or to produce and sell for
w

the growing demand of 5,000 units at the rate of rs.12.50. Give your advice
to the management in taking decision.
w

A publishing firm sells a popular novel at rs.15 each. At current sales


of 20,000 books, the firm breaks even. It is estimated that if the authors
royalties were reduced, the variable cost would drop by rs.1.00 to rs.7.00
per book. Assume that the royalties were reduced by rs.1.00, that the price
of the book is reduced to rs.12 and that this price reduction increases sales
from 20,000 to 30,000 books. What are the publishers profits, assuming
that fixed costs do not change?

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An analysis of a manufacturing co. Led to the following information:


Variable Cost Fixed Cost
Cost Element (% Of Sales) Rs.
Direct Material 32.8
Direct Labour 28.4
Factory Overheads 12.6 1,89,900
Distribution Overheads 4.1 58,400
General Administration Overheads 1.1 66,700
Budgeted Sales Rs.18,50,000
You are required to determine:
(a) the break-even sales volume
(b) the profit at the budgeted sales volume
(c) the profit if actual sales

m
(i) drop by 80%

co
(ii) increase by 5% from budgeted sales.

s.
4.2.3.10 Key To Self Assessment Questions
bu
(for problems only)
Q.No.4: (A) Rs.7,50,000; (B) 40%; (C) 25%
la

Q.No.5: The Proposal Is Profitable


Q.No.6: Rs.10,000
yl

Q.No.7: (A) Rs.15,000; (B) Rs.73,000; (C) (I) Rs.34,650; (Ii) Rs.9,925
lls

4.2.3.11 Case Analysis


.a
w

The directors of anandam ltd. Provide you the following data relating to
w

the cylce chain manufactured by them:


Rs.
w

Sales 4,000 units @rs.50 each 2,00,000


Production cost details: Rs.
Materials consumed 80,000
Labour cost 40,000
Variable overheads 20,000
Fixed overheads 30,000 1,70,000
---------- ----------
Profit 30,000
----------

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They require you to answer their following queries:


(i) the number of units by selling which the company will be
At break-even.
(ii) the sales needed to earn a profit of 20% on sales.
(iii) the extra units which would be sold to obtain the present
Profit if it is proposed to reduce the selling price by 20%

Solution:

(i) Break Even Units:


Fixed Cost Rs.30,000
-------------------------- = -------------- = 2000 Units
Contribution Per Unit Rs.15

m
(Ii) Sales To Earn 20% On Sales

co
Let the units to be sold to earn 20% be x. Therefore sales will be 50x and
profit is 20% of 50x i.e. 10x.
s.
Now The Total Sales Should Be Fixed Cost + Variable Cost + Profit
bu
Is
50x = 30000 + 35x + 10x
la

5x = 30000
x = 6000 units
yl

Therefore sales required is 6000 units x Rs.50 = Rs.3,00,000


lls

(iii) extra units to be sold if selling price is reduced by 20%.


Present Selling Price Rs.50
.a

Less 20% Rs.10


w

-------
w

New Selling Price Rs.40


Less Variable Cost Rs.35
w

-------
Contribution Rs. 5
-------

Fixed Cost + Target Profit


Units To Be Sold = -------------------------------
Contribution
30,000 + 30,000
= -------------------- = 12000 Units
5
Extra Units To Be Sold =12000 4000 = 800 Units

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4.2.3.12 Books For Further Reading

1.P.Das Gupta: Studies In Cost Accounting, Sultan Chand & Sons,


New Delhi.
2.Jain & Narang: Advanced Cost Accounting, Kalyani Publishers.
3.Jawaharlal: Advanced Management Accounting, S.Chand & Co.
4.S.N.Maheswari: Management Accounting And Financial Control,
Sultan Chand & Sons.
5.V.K.Saxena And C.D.Vashist: Advanced Cost And Management
Accounting, Sultan Chand & Sons, New Delhi.

*****

m
co
s.
bu
la
yl
lls
.a
w
w
w

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UNIT V: Cost Estimation And Control

Lesson 5.1 Cost Accounting

5.1.1 Introduction

Accounting can no longer be considered a mere language of


business. The need for maintaining the financial chastity of business
operations, ensuring the reliability of recorded experience resulting from
these operations and conducting a frank appraisal of such experiences
has made accounting a prime activity along with such other activities as
marketing, production and finance. Accounting may be broadly classified

m
into two categories accounting which is meant to serve all parties

co
external to the operating responsibility of the firms and the accounting,
which is designed to serve internal parties to take care of the operational
s.
needs of the firm. The first category, which is conventionally referred to
bu
as financial accounting, looks to the interest of those who have primarily
a financial stake in the organisations affairs creditors, investors,
la

employees etc. On the other hand, the second category of accounting is


primarily concerned with providing information relating to the conduct
yl

of the various aspects of a business like cost or profit associated with some
lls

portions of business operations to the internal parties viz., management.


This category of accounting is divided into management accounting and
.a

cost accounting. This section deals with cost accounting.


w
w

5.1.2 Learning Objectives


w

After reading this lesson, the reader should be able to:

understand the different dimensions of cost accounting.


distinguish cost accounting from financial accounting.
appreciate the utility of cost accounting.
apply the various bases of classification of costs.
prepare a cost sheet or tender or quotations.

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5.1.3 Contents

5.1.3.1 Meaning Of Cost Accounting


5.1.3.2 Distinction Between Financial Accounting And Cost
Accounting
5.1.3.3 Utility Of Cost Accounting
5.1.3.4 Distinction Between Costing And Cost Accounting
5.1.3.5 Classification Of Cost
5.1.3.6 Cost Sheet
5.1.3.7 Illustrations
5.1.3.8 Summary
5.1.3.9 Key Words
5.1.3.10 Self Assessment Questions

m
5.1.3.11 Key To Self Assessment Questions

co
5.1.3.12 Case Analysis
5.1.3.13 Books For Further Reading
s.
bu
5.1.3.1 Meaning Of Cost Accounting
la

Cost accounting developed as an advanced phase of accounting


science and is trying to make up the deficiencies of financial accounts. It
yl

is essentially a creation of the twentieth century. Cost accounting accounts


lls

for the costs of a product, a service or an operation. It is concerned with


actual costs incurred and the estimation of future costs. Cost accounting is
.a

a conscious and rational procedure used by accountants for accumulating


w

costs and relating such costs to specific products or departments for


w

effective management action. Cost accounting through its marginal


costing technique helps the management in profit planning and through
w

its another technique i.e. Standard costing facilitates cost control. In short,
cost accounting is a management information system which analyses
past, present and future data to provide the basis for managerial decision
making.

5.1.3.2 Distinction Between Financial Accounting And


Cost Accounting

Though there is much common ground between financial accounting


and cost accounting and though in fact cost accounting is an outgrowth of
financial accounting yet the emphasis differs. Firstly financial accounting

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is more attached with reporting the results of business to persons other


than internal management government, creditors, investors, researchers,
etc. Cost accounting is an internal reporting system for an organisations
own management for decision making. Secondly financial accounting data
is historical in nature and its periodicity of reporting is much wider. Cost
accounting is more concerned with short-term planning and its reporting
period much lesser than financial accounting. It not only deals with historic
data but also is futuristic in approach. Thirdly, in financial accounting the
major emphasis in cost classification is based on the type of transaction e.g.
Salaries, repairs, insurance, stores, etc. But in cost accounting the major
emphasis is on functions, activities, products, processes and on internal
planning and control and information needs of the organisation.

m
5.1.3.3 Utility Of Cost Accounting

co
A properly installed cost accounting system will help the
management in the following ways: s.
bu
- the analysis of profitability of individual products, services or jobs.
- the analysis of profitability of different departments or operations.
la

- it locates differences between actual results and expected results.


- it will assist in setting the prices so as to cover costs and generate an
yl

acceptable level of profit.


lls

- cost accounting data generally serves as a base to which the tools and
techniques of management accounting can be applied to make it more
.a

purposeful and management oriented.


w

- the effect on profits of increase or decrease in output or shutdown of a


w

product line or department can be analysed by adoption of efficient cost


accounting system.
w

5.1.3.4 Distinction Between Costing And Cost Accounting

Costing is the technique and process of ascertaining costs. It tries


to find out the cost of doing something, i.e., the cost of manufacturing an
article, rendering a service, or performing a function. Cost accounting
is a broader term, in that it tries to determine the costs through a formal
system of accounting (unlike costing which can be performed even through
informal means). Stated precisely, cost accounting is a formal mechanism
by means of which costs of products and services are ascertained and
controlled. The institute of cost and management accountants, u.k. define

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cost accounting as: the application of accounting and costing principles,


methods and techniques in the ascertainment of costs and the analysis
of savings and/or excesses as compared with previous experience or with
standards. It, thus, includes three things:
Cost Ascertainment: finding out the specific and precise total and
unit costs of products and services.
Cost Presentation: reporting cost data to various levels of management
with a view to facilitate decision making.
Cost Control: this consists of estimating costs for production and
activities for the future, and keeping them within proper limits.
Budgets and standards are employed for this purpose.
Cost accounting also aims at cost reduction, i.e., achieving a
permanent and real reduction in cost by improving the standards. Cost

m
accountancy is a comprehensive term that implies the `application of

co
costing and cost accounting principles, methods and techniques to the
science, art and practice of cost control. It seeks to control costs and
s.
ascertain the profitability of business operations.
bu
5.1.3.5 Classification Of Cost
la

In the process of cost accounting, costs are arranged and rearranged


yl

in various classifications. The term `classification refers to the process of


lls

Grouping costs according to their common characteristics. The different


bases of cost classification are:
.a

1. By nature or elements (materials, labour and overheads)


w

2. By time (historical, pre-determined)


w

3. By traceability to the product (direct, indirect)


4. By association with the product (product, period)
w

5. By changes in activity or volume (fixed, variable, semi-variable)


6. By function (manufacturing, administrative, selling, research
and development, pre-production)
7. By relationship with the accounting period (capital, revenue)
8. By controllability (controllable, non-controllable)
9. By analytical/decision-making purpose (opportunity, sunk,
differential, joint, common, imputed, out-of-pocket, marginal,
uniform, replacement)
10. By other reasons (conversion, traceable, normal, avoidable,
unavoidable, total)

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1. Elements Of Cost

The elements of costs are the essential part of the cost. There are
broadly three elements of cost, as explained below:

(A) Material

The substance from which the produce is made is called material.


It can be direct as well as indirect.
I) Direct Material: it refers to those materials which become an integral
part of the final product and can be easily traceable to specific physical
units. Direct materials, thus, include:
1. All materials specifically purchased for a particular job or process.

m
2. Components purchased or produced.

co
3. Primary packing materials (e.g., carton, wrapping, card-board
boxes etc.).
4. Material passing from one process to another. s.
bu
Ii) Indirect Material: all materials which are used for purpose ancillary
la

to the business and which cannot conveniently be assigned to specific


physical units are known as `indirect materials. Oil, grease, consumable
yl

stores, printing and stationery material etc. Are a few examples of indirect
lls

materials.
.a

(b) Labour
w

In order to convert materials into finished products, human effort is


w

required. Such human effort is known as labour. Labour can be direct as


well as indirect.
w

I) Direct Labour:

It is defined as the wages paid to workers who are engaged in the


production process and whose time can be conveniently and economically
traceable to specific physical units. When a concern does not produce but
instead renders a service, the term direct labour or wages refers to the cost
of wages paid to those who directly carry out the service, e.g., wages paid
to driver, conductor etc. Of a bus in transport service.

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Ii) Indirect Labour:

Labour employed for the purpose of carrying out tasks


Incidental to goods produced or services provided is called indirect labour
or indirect wages. In short, wages which cannot be directly identified with a
job, process or operation, are generally treated as indirect wages. Examples
of indirect labour are: wages of store-keepers, foremen, supervisors,
inspectors, internal transport men etc.

(C) Expenses
Expenses may be direct or indirect.

I) Direct Expenses:

m
co
These are expenses which can be directly, conveniently and wholly
identifiable with a job, process or operation. Direct expenses are also
s.
known as chargeable expenses or productive expenses. Examples of such
bu
expenses are: cost of special layout, design or drawings, hire of special
machinery required for a particular contract, maintenance cost of special
la

tools needed for a contract job, etc.


yl

Ii) Indirect Expenses:


lls

Expenses which cannot be charged to production directly and which


.a

are neither indirect materials nor indirect wages are known as indirect
w

expenses. Examples are rent, rates and taxes, insurance, depreciation,


w

repairs and maintenance, power, lighting and heating etc.


w

The above elements of cost may be shown by means of a chart:


Element of cost
materials labour expenses
Direct indirect direct indirect direct indirect

1. Overheads

The term overheads includes, indirect material, indirect labour and


indirect expenses, explained in the preceding paragraphs. Overheads may
be incurred in the factory, office or selling and distribution departments/
divisions in an undertaking. Thus overheads may be of three types: factory

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overheads, office and administrative overheads and selling and distribution


overheads. This classification of overheads may be shown thus:

Classification Of Overheads

Overheads
Factory office selling and distribution
Indirect indirect indirect indirect indirect indirect indirect indirect indir
Material labour exp mat lab. Exp. Mat. Lab exp

2. Cost Classification By Time

m
On the basis of the time of computing costs, they can be classified

co
Into historical and pre-determined costs.

I) Historical Costs: s.
bu
These costs are computed after they are incurred. Such costs are
la

available only after the production of a particular thing is over.


yl

Ii) Pre-Determined Costs:


lls

These costs are computed in advance of production on the basis of


.a

a specification of all factors influencing cost. Such costs may be:


w
w

1. Estimated costs: estimated costs are based on a lot of guess


work. They try to ascertain what the costs will be based on certain factors.
w

They are less accurate as only past experience is taken into account
primarily, while computing them.

2. Standard costs: standard costs is a pre-determined cost


based on a technical estimate for material, labour and other expenses for a
selected period of time and for a prescribed set of working conditions. It is
more scientific in nature and the object is to find out what the costs should
be.

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3. Cost Classification By Traceability

As explained previously, costs which can be easily traceable


to a product are called direct costs. Indirect costs cannot be traced to a
product or activity. They are common to several products (e.g., salary of
a factory manager, supervisor etc.) And they have to be apportioned to
different products on some suitable basis. Indirect costs are also called
`overheads.

4. Cost Classification By Association With Product

Costs can also be classified (on the basis of their association with

m
products) as product costs and period costs.

co
1.Product Costs: product costs are traceable to the product and
include direct material, direct labour and manufacturing overheads. In
s.
other words, product cost is equivalent to factory cost.
bu
2.Period Costs: period costs are charged to the period in which
they are incurred and are treated as expenses. They are incurred on the
la

basis of time, e.g., rent, salaries, insurance etc. They cannot be directly
assigned to a product, as they are incurred for several products at a time
yl

(generally).
lls

5. Cost Classification By Activity/Volume


.a
w

Costs are also classified into fixed, variable and semi-variable on


w

the basis of variability of cost in the volume of production.


w

1.Fixed Cost:

Fixed cost is a cost which tends to be unaffected by variations in


volume of output. Fixed cost mainly depends on the passage of time and
does not vary directly with the volume of output. It is also called period
cost, e.g., rent, insurance, depreciation of buildings etc. It must be noted
here that fixed costs remain fixed upto a certain level only. These costs
may also vary after a certain production level.

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2.Semi-Variable Cost:

These costs are partly fixed and partly variable. Because of the
variable element, they fluctuate with volume and because of the fixed
element, they do not change in direct proportion to output. Semi-variable
or semi-fixed costs change in the same direction as that of the output but
not in the same proportion. For example, the expenditure on maintenance
is to a great extent fixed if the output does not change significantly. Where,
however, the production rises beyond a certain limit, further expenditure
on maintenance will be necessary although the increase in the expenditure
will not be in proportion to the rise in output. Other examples in this
regard are: depreciation, telephone rent, repairs etc.

m
3.Variable Cost:

co
Cost which tends to vary directly with volume of outputs is called
s.
`variable cost. It is a direct cost. It includes direct material, direct labour,
bu
direct expenses etc. It should be noted here that the variable cost per unit
is constant but the total cost changes corresponding to the levels of output.
la

It is always expressed in terms of units, not in terms of time.


yl

6. Cost Classification By Function


lls

On the basis of the functions carried out in a manufacturing concern,


.a

Costs can be classified into four categories:


w

1.Manufacturing/Production Cost: it is the cost of operating the


w

manufacturing division of an enterprise. It is defined as the cost of the


sequence of operations which begin with supplying materials, services and
w

ends with the primary packing of the product.

2Administrative/Office Cost: it is the cost of formulating the policy,


directing the organisation and controlling the operations of an undertaking,
which is not directly related to production, selling, distribution, research
or development. Administration cost, thus, includes all office expenses:
remuneration paid to managers, directors, legal expenses, depreciation of
office premises etc.

3.Selling Cost: selling cost is the cost of seeking to create and


stimulate demand e.g., advertisements, show room expenses, sales

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promotion expenses, discounts to distributors, free repair and servicing


expenses, etc.

4.Distribution Cost: it is the cost of the sequence of operations


which begins with making the packed product, available for despatch
and ends with making the reconditioned returned empty package, if any,
available for re-use. Thus, distribution cost includes all those expenses
concerned with despatching and delivering finished products to customers,
e.g., warehouse rent, depreciation of delivery vehicles, special packing,
loading expenses, carriage outward, salaries of despatch clerks, repairing
of empties for re-use, etc.

5. Research And Development Cost: it is the cost of discovering

m
new ideas, processes, products by experiment and implementing such

co
results on a commercial basis.

s.
6.Pre-Production Cost: expenses incurred before a factory is started
bu
and expenses involved in introducing a new product are preproduction
costs. They are treated as deferred revenue expenditure and charged to the
la

cost of future production on some suitable basis.


yl

7. Cost Classification By Relationship With Accounting Period


lls

On the basis of controllability, costs can be classified as controllable or


.a

uncontrollable.
w

1.Controllable Cost: a cost which can be influenced by the action


w

of a specified member of an undertaking is a controllable cost, e.g., direct


materials, direct labour etc.
w

2.Uncontrollable Cost: a cost which cannot be influenced by the


action of a specified member of an undertaking is an uncontrollable cost,
e.g., rent, rates, taxes, salary, insurance etc.

The term controllable cost is often used in relation to variable


cost and the term uncontrollable cost in relation to fixed cost. It should
be noted here that a controllable cost can be controlled by a person at a
given organisation level only. Sometimes two or more individuals may be
involved in controlling such a cost.

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8. Cost Classification By Decision-Making Purpose

Costs may be classified on the basis of decision-making purposes


for which they are put to use, in the following ways:
1.Opportunity Cost: it is the value of the benefit sacrificed in
favour of choosing a particular alternative or action. It is the cost of the
best alternative foregone. If an owned building, for example, is proposed
to be used for a new project, the likely revenue which the building could
fetch, when rented out, is the opportunity cost which should be considered
while evaluating the profitability of the project.

2.Sunk Cost: a cost which was incurred or sunk in the past and
is not relevant for decision-making is a sunk cost. It is only historical in

m
nature and is irrelevant for decision-making. It may also be defined as the

co
difference between the purchase price of an asset and its salvage value.

s.
3.Differential Cost: the difference in total costs between two
bu
alternatives is called as differential cost. In case the choice of an alternative
results in increase in total cost, such increase in costs is called `incremental
la

cost. If the choice results in decrease in total costs, the resulting decrease is
known as decremental cost.
yl
lls

4.Joint Cost: whenever two or more products are produced out of


one and the same raw material or process, the cost of material purchased
.a

and the processing are called joint costs. Technically speaking, joint cost
w

is that cost which is common to the processing of joint products or by-


w

products upto the point of split-off or separation.


w

5.Common Cost: common cost is a cost which is incurred for more


than one product, job territory or any other specific costing object. It
cannot be treated to individual products and, hence, apportioned on some
suitable basis.

6.Imputed Cost: this type of cost is neither spent nor recorded


in the books of account. These costs are not actually incurred (hence
known as hypothetical or notional costs) but are considered while making
a decision. For example, in accounting, interest and rent are recognized
only as expenditure when they are actually paid. But in costing, they are
charged on a notional basis while ascertaining the cost of a product.

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7.Out-Of-Pocket Cost: it is the cost which involves current or


future expenditure outlay, based on managerial decisions. For example
a company has its own trucks for transporting goods from one place to
another. It seeks to replace these by employing public carriers of goods.
While making this decision, management can ignore depreciation, but not
the out-of-pocket costs in the present situation, i.e., fuel, salary to drivers
and maintenance paid in cash.

8.Marginal Cost: it is the aggregate of variable costs, i.e., prime cost


plus variable overheads.

9.Replacement Cost: it is the cost of replacing a material or asset in


the current market.

m
co
5.1.3.6 Cost Sheet

s.
Cost sheet is a statement presenting the items entering into cost
bu
of products or services. It shows the total cost components by stages and
cost per unit of output during a period. It is usually prepared to meet three
la

objectives: to provide the classification of costs in a summarised form, to


prepare estimates of costs for future use and to facilitate a comparative
yl

study of costs with previous cost sheets to know the cost trends.
lls
.a
w
w
w

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The layout of a typical cost sheet is provided below:


Specimen cost sheet

Particulars Total cost Cost per Unit


Direct materials
opening stock of materials
add purchases of materials
less closing stock of materials
(a) materials consumed

Direct wages

Direct expenses

m
Prime cost

co
Add Factory Overheads
Factory Rent, Rates, Taxes
Fuel-Power And Water
Lighting And Heating
s.
bu
Indirect Wages
Salaries Of Works Manager Etc.
la

Indirect Materials
Drawing Office And Works Office Expenses
yl

Depreciation On Factory Land And


lls

Building
Less Scrap Value
Defective Work
.a

Add Work In Progress (Opening)


w

Less Work In Progress (Closing)


w

Works cost
Add Office/Administration Overheads
w

Office Rent, Insurance, Lighting, Cleaning


Office Salaries, Telephone, Law And
Audit Expenses
General Managers Salary
Printing And Stationery
Maintenance, Repairs, Upkeep Of Office
bldg
bank charges and miscellaneous expenses

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Cost Of Production
Add opening stock of finished goods
Less closing stock of finished goods
Cost of goods sold
Add selling and distribution overheads
showroom expenses, salesmens salaries
& commission, bad debts, discounts,
warehouse rent, carriage outwards,
advertising, delivery expenses, samples and
free gifts etc.
ost of sales
add net profit or deduct net loss:

m
Sales

co
s.
Treatment of certain items in the cost sheet:
bu
(a) Computation Of Profit: profit may be calculated either as a
Percentage of cost or selling price.
la

Example: profit as a percentage of cost:


Factory cost 5,700
yl

Administration overhead 600


lls

-------
Total cost 6,300
.a

-------
w

Profit 10% on cost 630


w

-------
Selling price 6,930
w

-------
percent
So profit = cost -------------
100
Example: Profit as a percentage of selling price. Here the percentage is on
Selling price. Selling price includes Cost + Profit.
Sales price = 100
Less profit = 10
----
Cost price = 90
----

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This profit of rs.10 is on rs.90 which is the cost price. So it is 1/9th of cost
price. In the above example,
Total cost = 6,300
Profit on 10% on SP = 700
-------
Selling price 7,000
-------
Cost x percent
So sale price = -------------------
100 percent
6,300 x 100
= -----------------
100 - 10

m
= 7,000

co
(b) Treatment Of Stock: the term `stock includes three items: raw materials,
work in progress and finished goods. The value of raw materials is arrived
at in the following manner: s.
bu
Opening stock of raw material
la

Add purchases
Add expenses involved in the purchases of raw material
yl

Less closing stock of raw materials


lls

Work-in-progress represents the quantity of semi-finished goods at


the time of the preparation of the cost sheet. It represents cost of materials,
.a

labour and manufacturing expenses to-date. Work-in-progress may be


w

shown in the cost sheet either immediately after the prime cost or after
w

the calculation of the factory overheads, as shown in the specimen cost


sheet. Finally, in respect of stock of finished goods, adjustments have to be
w

made where opening and closing stock of finished goods are given. This
is done, as shown in the specimen cost sheet, by adding opening stock of
finished goods to the cost of production arrived at on the basis of current
figures and reducing the closing stock of finished goods from this total.
Lets explore these aspects more clearly through the following illustrations:

Tenders And Quotations:

While preparing tenders or quotations, manufacturers or


contractors have to look into the figures pertaining to the previous year as
shown in the cost sheet for that period. These figures have to be suitably

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modified in the light of changes expected in the prices of materials, labour,


etc., and submit the tender or quotation accordingly.

5.3.6 Illustrations

Illustration 1:

Prepare the cost sheet to show the total cost of production and cost
per unit of goods manufactured by a company for the month of july 2012.
Also find out the cost of sales.

Stock of raw materials 1-7-2012 3,000


Raw materials purchased 28,000

m
Stock of raw materials 31-7-2012 4,500

co
Manufacturing wages 7,000
Depreciation of plant 1,500
s.
Loss o n sale of a part of plant 300
bu
Factory rent and rates 3,000
Office rent 500
la

General expenses 400


Discount on sales 300
yl

Advertisement expenses to be fully charged 600


lls

Income-tax paid 2,000


The number of units produced during july, 2012 was 3,000.
.a

The stock of finished goods was 200 and 400 units on 1-7-2012 and
w

31-7-202 respectively. The total cost of units on hand on 1-7-2012 was


w

Rs.2,800. All these have been sold during the month.


w

Output 3,000 units.


Cost sheet for the year ended 31-7-2012
Particulars Total Cost Per Unitcost
Rs. Rs.
Raw materials consumed
Opening stock 3,000
Add purchases 28,000
---------
31,000
Less closing stock 4,500 26,500 8.83
--------

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Direct wages 7,000 2.33


------- --------
Prime cost 33,500 11.16
Factory overheads:
Depreciation 1,500
Factory rent 3,000 4,500 1.50

Factory cost 38,000 12.66
Office and administrative
Overheads:
Office rent 500
General expenses 400 900 0.30

m
Cost of production 38,900 12.96

co
Statement of cost of sales
Cost of production 38,900s.
bu
Add: opening stock of
Finished goods 2,800
la

---------
41,700
yl

Less: closing stock of finished


lls

Goods (400 x rs.12.96) 5,184


--------
.a

Cost of production of goods sold 36,516


w

Add: selling and distribution overhead:


w

Discount on sales 300


Advertisement expenses 600 900
w


Cost of sales 37,416

Illustration 2:

From the following particulars, prepare a cost sheet for the year
ending 31-12-2011.

Opening stock of raw materials (1-1-2011) 50,000


Purchases of raw materials 1,60,000
Closing stock of raw materials (31-12-2011) 80,000

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Wages productive 1,50,000


general 20,000
Chargeable expenses 40,000
Rent, rates and taxes factory 10,000
Rent, rates and taxes office 1,000
Depreciation on plant and machinery 3,000
Salary office 5,000
Salary travellers 4,000
Printing and stationery 1,000
Office cleaning and lighting 800
Repairs and renewals (factory) 6,400
Other factory expenses 5,000
Management expenses (including managing

m
Directors fees) 24,000

co
Travelling expenses of salesmen 2,200
Showroom expenses and samples 2,000
Carriage and freight outwards s. 2,000
bu
Carriage and freight inwards 9,000
Octroi on purchases 1,000
la

Advertisement 30,000
Sales 4,60,000
yl

Management expenses should be allocated in the ratio of 2:1:3 on factory,


lls

office and sales departments.


Solution:
.a

Statement of cost and profit for 2011


w

Rupees Rupees
w

Materials consumed
Opening stock 50,000
w

Add purchases 1,60,000


Add carriages freight inwards 9,000
Add octroi on purchases 1,000
-----------
2,20,000
Less closing stock 80,000
-----------
Cost of materials used 1,40,000
Productive wages 1,50,000
Chargeable expenses 40,000
Prime cost 3,30,000

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Factory expenses
General wages 20,000
Rent, rates and taxes 10,000
Depreciation on plant and
Machinery 3,000
Repairs and renewals 6,400
Other factory expenses 5,000
Management expenses: 1/6 of Rs.24,000 8,000 52,400
-------- ---------
Factory cost 3,82,400
Administrative expenses
Rent, rates and taxes 1,000

m
Salary 5,000

co
Printing and stationery 1,000
Cleaning and lighting 800
Management expenses:1/6 s.
bu
of Rs.24,000 4,000 11,800
----------
la

Cost of production 3,94,200


yl
lls

Selling and distribution expenses


Advertising 4,000
.a

Show-room expenses and samples 2,000


w

Travellers salary 4,000


w

Salesmens travelling expense 2,200


Carriage outwards and freight 2,000
w

Management expenses: 3/6 of


Rs.24,000 12,000 26,200

Cost of sales 4,20,400


Sales 4,60,000
---------
Profit 39,600
---------
---------------------------------------------------------------------------------

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Illustration 3:

the following particulars relate to a company for a period of


Three months:
Raw materials (1-1-2012) 55,000
Raw materials (31-3-2012) 35,000
Factory wages 80,000
Materials purchased 60,000
Sales 1,54,000
Indirect expenses 10,000
Stock of finished goods (1-1-2012) NIL
Stock of finished goods (31-3-2012) 30,000
No. Of units produced during the period was 2,000.

m
Prepare a statement of cost for the period and compute the price to be

co
quoted for 500 units in order to realise the same profit as for the period
under review, assuming no alternation in wages and cost of materials.
s.
bu
Solution:
la

Statement of cost for the period ending 31-3-2012


Output 2,000 Units
yl

Particulars Amount
lls

Rs. Rs.
---------------------------------------------------------------------------------
.a

Opening stock of raw materials 55,000


w

Add: purchases 60,000


w

---------
1,15,000
w

Less: closing stock of raw materials 35,000


---------
Raw materials consumed 80,000
Factory wages
80,000
---------
Prime cost 1,60,000
Indirect expenses 10,000
----------
Cost of production 1,70,000
Less: closing stock of finished goods 30,000
----------

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Cost of goods sold


1,40,000
14,000 x 100
Profit ( -------------------- ) = 10% of cost
1,40,000
14,000
----------
Sales 1,54,000
---------
Tender statement showing quotations for 500 units
Particulars Amount
Rupees
---------------------------------------------------------------------------------

m
co
80,000 x 500
Materials consumed ( ---------------- )
2,000 s.
20,000
bu
80,000 x 500
Wages ( -----------------) 20,000
la

2,000 ---------
Prime cost 40,000
yl

10,000 x 500
lls

Add: indirect expenses ( ----------------- ) 2,500


2,000 --------
.a

Cost of production 42,500


w

Add: profit (10% of cost of production) 4,250


w

----------
Price to be quoted 46,750
w

---------

Illustration 4: The following information has been taken from a factory:


Rupees
Materials 50,000
Direct wages 40,000
Factory overheads 30,000
Administration overheads 20,000
You are required to fix the selling price of a machine costing rs.4,200 in
materials and rs.3,000 in wages so that it yields a profit of 25% on selling
price.

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Solution:
Statement of cost Rupees
Materials 50,000
Direct wages 40,000
---------
Prime cost 90,000
Factory overheads 30,000
----------
Works cost 1,20,000
Administration overheads 20,000
----------
Cost of production 1,40,000
----------

m
Percentage of factory overheads to direct wages:

co
30,000
------------ x 100 = 75%
40,000 s.
bu
Percentage of office overheads to works cost:
20,000
la

-------------- x 100 = 16.67%


1,20,000
yl
lls

Tender or quotation
Rupees
.a

Materials 4,200
w

Wages 3,000
w

-------
Prime cost 7,200
w

Factory overheads - 75% of wages 2,250


-------
Works cost 9,450
Administration overheads 16.67% on
Works cost 1,575
--------
Cost of production 11,025
Profit 25% on selling price or
33 1/3
33 1/3% on cost 11,025 x ----------- 3,675
100

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--------
Estimated selling price 14,700
-------
5.1.3.8 Summary

Traditional accounting or financial accounting can no longer serve


the purposes of all concerned. Especially the internal organs of the business
concerns, namely managements, want a lot of analytical information
which could not be provided by the financial accounting. Hence to serve
the needs of management two more kinds of accounts management
accounting and cost accounting have evolved. Simply stated, management
accounting serves the needs of management and cost accounting tries to
determine the costs through a formal system of accounting. Costs can be

m
classified on various bases and cost sheet is a statement presenting the

co
items entering into cost of products or services.

5.1.3.9 Key Words s.


bu
Direct Expenses: expenses that can easily be identified with a particular
la

product.
Indirect Expenses: expenses which cannot be easily identified with a
yl

particular product.
lls

Overheads: total of all indirect expenses.


Works Cost: prime cost + factory overheads.
.a

Cost Of Production: works cost + administration overheads.


w

Cost Of Sales: cost of production + selling and distribution overheads.


w

Cost Sheet: a statement which is prepared to ascertain the cost of sales.


Tenders: a statement which quotes the price for a particular job or level of
w

production activity.

5.3.10 Self Assessment Questions

1.What are the limitations of financial accounting?


2.Justify the need for cost accounting.
3.Explain the various bases for classification of costs.
4.What are the differences between a `cost sheet and `tender.
5.Prepare a cost sheet for the production of 100 units of an article
using imaginary figures.
6.Prepare a statement of cost showing:

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(a) value of materials consumed


(b) total cost of production
(c) cost of goods sold and
(d) the amount of profit
From the following details relating to a toy manufacturing concern:
Rupees
Opening stock: raw materials 25,000
finished goods 20,000
Raw materials purchased 2,50,000
Wages paid to labourers 1,00,000
Closing stock: raw materials 20,000
finished goods 25,000
Chargeable expenses 10,000

m
Rent, rates and taxes (factory) 25,000

co
Motive power 10,000
Factory heating and lighting 10,000
Factory insurance s. 5,000
bu
Experimental expenses 2,500
Waste materials in factory 1,000
la

Office salaries 20,000


Printing and stationery 1,000
yl

Salesmens salary 10,000


lls

Commission to travelling agents 5,000


Sales 5,00,000
.a
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7.Kolam products ltd., produces a stabilizer that sells for rs.300. An


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increase of 15% in the cost of materials and 10% in the cost of labour is
anticipated. If the only figures available are those given below, wha